Term Paper_Contemporary Banking_The primacy of Asset Liability Management Strategy in banks and its...

The primacy of Asset Liability Management Strategy in banks and its impact in quasi -reformed banking structures Setting the path for a renewed industry to tread responsibly and face up to growth

Amit Mittal Pursuing a Ph. D. in Finance FPM15003

Submitted to Prof Prakash Singh

Keywords: Asset Liability Management, Maturity Transformation, Emerging Markets, India, China, Asia, Commercial Banking, Treasury Management

INDIAN INSTITUTE OF MANAGEMENT

LUCKNOW

Contemporary Research in Banking and Risk Amit Mittal, FINANCE, FPM15003 Management

2

The primacy of

Asset Liability

Management

Strategy in banks

and its impact in

quasi-reformed

banking

structures Setting the path for a renewed industry to tread responsibly and face up to growth

Abstract: After a debilitating crisis, returning to

the job at hand in absence of wholesale banking

markets in the domestic industry, makes banks’

tasks unique and time consuming in India. Banks

in India have shown the advantages of being

partners in the policy making and Economic

development process. They have been

recognized as leading the institutional

juggernaut across the world at the forefront of

profitability scores till before the crisis but

increasingly face up to larger NPAs and

decimated opportunities for Direct lending,

which can be a bane without lack of specialized

secondary markets. Primary Treasury Operations

cannot substitute for Risk Management in

lending though there are advantages to a

conservative banking structure still lending 75%

of its asset portfolio transforming deposits from retail branch networks

Keywords: Asset Liability Management,

Maturity Transformation, Emerging Markets,

India, China, Asia, Commercial Banking, Treasury Management, Technology

Introduction

Traditional asset liability management accounts

for a majority of the bank’s wealth especially

when supplemented by modern Financial

technology that has globally led to intense use of

interest rate swaps and other derivatives or

financial innovations to bridge the duration gap

carried between assets and liabilities in

incomplete and complete hedges and / or

speculation by the Bank’s Treasury to accrue

additional profits to that earned by Net Interest

Income from assets and Fee Income from Retail

consumers, Corporates and or Investment

Banking and Transaction Banking clients.

However, while Banks in India increasingly

ramped up the use of swaps in the last decade or

two for itself and for its lending clients, they still

rely on the structured traditional asset liability

management to support business which in

operational terms accounts for deposits and

corresponding lending with limited recourse to

wholesale lending markets, directly interceding

in the inter-bank markets for requirements

including that of statutory reserves.

Governments have to step in directly to fund

banks’ balance sheets to make up for any gap

caused by inopportune lending and other forced

NPAs recently brought round to higher levels

through a twin move in completing

systemization and a contraction of demand in

lending markets as recovery takes its time to set in.

Investigating ALM strategies: A Review of

the Literature

DeYoung et al (2008) comment on the

characteristics of ALM strategies in the context

of the other large universal banking system of

the US which along with China is frequently cited


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in popular literature. The US system shows up a

distinct breach in the national banking industry

structure in the pre-crisis days enabling a new

classification of banks with weaker ALM and

stronger on risk mitigation strategies. Even in the

US large banks remain strongly affiliated with

traditional ALM underlining the criticality of the

strategy for banks. In effect the paper manages

to convey the primacy of ALM in Bank

management, forcing smaller banks to adopt the

universal practice to lend stability to their

balance sheets.

In contrast to India, US banking markets and in

fact all US funding markets heavily rely on the

skewed strategy of funding longer term assets

with shorter liabilities as the ‘normal’ upward

rising yield curve turns it more profitable.

Needless to say, the strategy is higher on interest

rate risk and in fact the authors go on to blame it

in part for the 2008 crisis. The strategy is enticing

for smaller banks in the thrifts sector that rely on

higher cost deposits and yet are a constant

burden on the exchequer with instant bailouts after a real estate crash.

In its simplest form the ALM strategy is a

duration based immunization strategy, liabilities

required to match assets’ duration to immunize

the portfolio from interest rate movements.

DeYoung uses canonical correlation analysis to

measure the matching of assets with liabilities

and equity whence its essential non directional

force accommodates banks with a primary

Deposit franchise and others with a primary loan

franchise. Saha, Basu et al (2009) develop the

evidence of ALM in the Indian Banking sector

with a cross section of rates in a term structure

with causal linkages to the evidenced interest rate risk.

In earlier papers we refer Song and Thakor

(2007) that creates a contrarian view against the

tenets of ALM for the case of relationship loans

but in general explore the loan by loan construct

of a qualitative basis for piecewise ALM for the

development of theory. Also in US banking

markets, the Central Bank discount window use

is limited to emergencies signaling weakness in

the banks’ strategy which we attribute to the

existence of deeper debt trading markets and a

larger network of relationships with investors

and banks that are the banks’ primary source of Capital. (Ennis and Weinberg, 2013)

Andreason and Ferman(2012) refer the

predominant use of the one period banking

model proposed by Diamond and Dybvig(1983)

as the reason why there is a lack of focus on

studies of the impact of ALM. The paper goes on

to evidence the beneficial dampening impact of

ALM strategy in propagation of economic shocks

providing a lag between the consumption and

investment response of a technology shock

Recent libations and their counter response

from regulators have also added a liquidity and

additional tangible equity leverage limitations on

banks’ balance sheets. Jean Dermine (2015)

relates the same to the ordinary maturity

mismatch model of the bank which makes it

subject to bank runs (ibid.) Both Andreason

(2013) and Dermine (2015) point to the

requirement of funding with short term deposits

as a response to the assumed liquidity risk from

deposits being withdrawable on demand and the

provision of liquidity thus being a challenge to

the Treasury’s immunization strategy.

Agca et al (2015) raise the concern relevant to

ALM in their contrast of Advanced Economies

and Emerging Markets that openness to Global

funding markets has led to shorter debt

maturities in the emerging Markets in the study.

Private Banks from India as well as PSBs now

frequently access International markets, for small tranches of capital infusion.

Entrop et al(2014) summarize the problem of

ALM thus: a reinvestment opportunity risk from

rolling contracts at a disadvantageous rate when

the term structure moves against you and a


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valuation risk from the changed valuation of the

assets as well as liabilities tackled in Saha, Basu

et al. (2009) IFRS regulations from 2016 (fully

turned in 2019) require marking to market of all

assets and liabilities in financial statements.

Banks, however do not mark such investments in

the HTM category to market values and carry

them at cost. Brunnermeier et al(2013)

additionally specify the continuing inability of

banks to handle liquidity shocks resulting from

the skewed build-up of deposits and assets. We

are convinced the short term opportunism of the

strategy has been shown up by the overuse of

the same by banks well exceeding the size where

they were disadvantaged to employ an end to

end ALM strategy.

The Brunnermeier et al (2013) model in

particular shows the reliance on creditors

instead of depositors to finance relationship

loans may offer a flawed dynamic that ends in

tears. This model (ibid) in particular provides a

clear picture as well on the disadvantage to

syndicate lenders in the case of traditional

models run in India without the mitigating

feature of secondary markets in debt and thus to

an extent over reliance on ALM strategy

Leveraged borrowing on the other hand

accelerates boom bust cycles in the economy as

a whole and traditional ALM strategies can easily

limit the exposure to such borrowings on the

bank balance sheet even if secondary debt

trading was to take off in the country providing

the flexibility of using other capital to finance

loans while fulfilling statutory bank capital and liquidity requirements.

Allen, Carletti et al(2014) develop a model of

liquidity provision by the interbank markets

depending on trading of not just interbank

liquidity but secondary sale of debt assets. The

model of course goes on to rigorously treat the

mitigation of illiquidity by well advised central

bank intervention. However, one can intuitively

ascribe a bigger challenge to this liquidity

provision in markets with only trading in pure liquidity such as in India

A Macroeconomic Bounty for India and

China

China has been much in the news as a new big

brother for the world at large, spreading its

global trade and investments during the

intervening crisis in line to grow to the highest

levels of GDP globally even as US stalls up during

2014 and 2015 ahead of the return of real

interest rates. Yet, China’s banks face an uphill

task lining up to a coming credit crunch before growth proceeds again.

India is also facing some challenges in reviving

growth and investment but though it relies on

banks for policy based growth leadership, banks

are professionally run entities facing a stigma in

consistent government largesse while facing up

to the challenge of fresh lending while making

adjustments for growing NPLs expected to peter out in 2016.

Both banking models remain tuned to ALM

based banking leadership maintaining a

relationship between deposits and credit, while

India’s policy denizens never seem to have a

problem of China’s size in Balance sheet holes

caused by inopportune NBFC and real estate lending.

Further research based on cross sectional

analysis of macroeconomic factors is likely to

show thus a more sustainable trajectory and

lesser required policy intervention in Indian

banks. In the current scenario, the most visible

gap between India and China in terms of

otherwise equable growth is the lack of scaling

up of credit in India because of the lack of

investor interest in protected debt markets that

constrain Indian debt to be traded and reduce

the available growth in the real economy.

Though that problem is not essentially that of

the banking sector, Bank ALM proceeds to give

us a viable safety wall in allowing more trading in


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debt and enabling a more efficient debt markets mechanism

Trading in Indian Debt Indian CDS trade at near the sovereign CDS

marks for the regularly traded name debts like

SBI and Reliance at near 160 bps which could

trade in more liquid markets and reduce the

reliance of banks and other issuers on the short

term debt markets from QIP investors. As studies

by Rao(2007) and others show, Indian Bank

profitability is best in class and NPL ratios are

unlikely to be as worrisome as in China or other

comparable markets in Asia and Europe. The

debt segment on the NSE shows the average

ticket size has increased to Rs 42.31 crores in the

current year to date with volumes of Rs 8 Trillion

in each of the last 3 years

That still means only 80 trades take place each

day while the interest term structure is still as

dynamic as in the liquid debt markets of US and

Europe.

In our specific context, this lack of depth in debt

trading is likely to be particularly challenging for

Bank Treasuries and shadow banking financial

institutions that trade for debt mutual funds and

Project Finance investment vehicles. Pricing for

sanctioned and private OTC debt deals that still

take place by phone as much as on Terminals is

definitely a weakness of these markets as most

of the literature on the subject and from the

crisis points to the wanton negotiating powers of

the traders in an OTC deal armed with

management sensitive information on the

counterparty making bank treasuries

characteristically more defensive players in the

market. Government treasuries make a large

proportion of these trades and banks continue to

hold larger than required high SLR and CRR requirements of 25.5% as of date.

There is no stigma or sloth associated with

holding more of liquid government securities yet

some of this excess inventory is a reaction to the

illiquidity of traded debt in the markets. Bank

sources suggest even for upbeat retail tranches

not more than a dozen securitization deals of

prime debt are conducted across private and

foreign banks and the presence of PSBs is

marked by just one or two players.

Institutional investors like LIC have virtually no

trading in debt while being on tap for Public IPOs

and running concentration risk in equities, a

situation of significant connotations when considering the difference in ticket sizes.

Foreign banks and ALM, and the inverted

yield curve

Claessens and Horens(2012) present an IMF

analysis of foreign banks the data wherein

confirms India’s situation to be aberrant to the

larger instability ascribed by foreign banks in

AEs (20% share of market) and Emerging

Markets (50% share of market) However , this

also means that foreign banks are choosing to

discard the extra regulatory burden and leave

the shores of India with just a 7% share of business after peaking in the double digits .

The dataset covers bank ownership till 2009 and

the analysis covers a balanced analysis of the

limitations of foreign players including the post crisis withdrawals from these markets

However even prior to this withdrawal post

crisis, foreign banks have notably been

significant underperformers in lending and carry

much weaker Lending Deposit Ratios

(alternatively Credit Deposit Ratios) especially in India and OECD countries.

This confirms that the current trend by

regulators to demand commitments from

Foreign Banks is a well thought out one and India

should continue to assess each such application

carefully. This section corrects any bias

purported to be in our analysis of the tea leaves

in laying the ground for good research. AE

models of macroeconomic determinants of term


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structure are also unlikely to be any secular

determinants of the determinants of term

premia or the requirements of a continuing

inverted yield curve with more uncertainty

perceived in longer maturity debt because of the

commitments as shorter term rates could

continue to be determined by temporary liquidity conditions.

Brick (2012) and Birge and Judice(2013)

technically present the definition and current

symptoms and targets for an optimal bank ALM

strategy. ALM strategies depend on both static

and dynamic simulations, including a Sims(1980)

advocated VAR simulation (VECM/Vector Auto

regression) and modeling interest rates nd the

consequent correlated impact on both dies of

the balance sheet. We recommend

Novickyte(2013) for the references in the extensive literature review.

Retail deposit rates continue to be a cheap

funding source in India, unlike the rigidity

evinced by near zero rates and the consequent

high relative cost of deposits denting bank

profitability measures in the US. Markowitz led

ALM models are out of scope of our analysis as

they represent work specific to Insurance

interests and have a limited applicability in Bank

balance sheets without perpetuities and no

significant exposure to stocks, though basic

stochastic models with some Markowitz like

characteristics are applicable. Simulation

methods and both stochastic and deterministic

implementations use linear and goal

programming to solve the ALM management problem for banks.

Short term rate moves hurt on the increasing

side if liabilities have to be refinanced while the

literature suggests that consistent asset growth

during booms is likely to result in an increase in

non-core liabilities (riskier liabilities to finance

the boom) thought despite a sustain 13% lending

growth across the last decade in India with a

near 20% lending asset growth in leading Private

sector traded and effective PSBs has not resulted

in such a capitalization conundrum for Indian

banks.

A review of quantitative ALM techniques

in the literature

Vector Auto Regression model in Birge and

Judice The bank has following assets and liabilities

Equity E, Loans L with Interest Income I and N

alludes to Non-core funding in the original model

but we use it for all other liabilities in the

absence of traded debt markets and in the

likelihood of Inter-bank markets and STF from

external QIPs making the difference

In the Indian scenario, Deposits grow at 15% in a

credit environment growing at a 17-18% rate and

the requirement of additional funds from Non

core deposits is probably not critical even after changes in the market structure

Taking a power utility and maximizing Expected

utility in a first order Taylor series expansion for

new Loans L* for new offtake n ( including retail and home loans as well as business lending)

L*=E.E(n)/αE(n^2)-L.E(n(old)*n)/E(n^2)

The model can also be simply extended in

determinate terms of L(t+1) and L(t) in the

balance sheet measures to track the move in

ALM assets and Liabilities with or without stochastic dependencies

However a simpler analysis is per se essential to

take into account the macro trading

manifestations of the ALM correction

mechanisms which are the first recourse. The

Asset Liability Management strategy chosen is a

function of the period of each correction and the

change in market value of the assets and

liabilities independently and together to the

same change in interest rates measured by

duration measures including Dollar Duration

more commonly referred to as the PVBP and the


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similar sensitivity of Income (Net Interest Income

) from that change in interest rates. The change

in liquidity assets of the bank from a measure of

the Dollar Duration will give a direct measure of

the Liquidity gap and will account for the

Liquidity Risk.

The Integrated ALM perspective Gulpinar and Pachamova(2013) also recognize

the importance of optimization but again include

the business of pension funds and insurance

companies and again focus on the problem of

extending ALM over infinite no. of periods as

possible computationally using a combination of

stochastic and dynamic programming

techniques. In our opinion such a

computationally intensive simulation and

optimization solution will require a few months

of being operationally implemented as ALM to

garner effectiveness from the data and

experience thence available and the problem is

not as dynamic with effective duration based

techniques able to tractably manage interest

rate, liquidity and profitability risks on a bank

balance sheet with a longer or medium term

Treasury strategy by savvy traders and

accountants. One needs to effectively monitor

time varying aspects of asset returns and interest

rates with the measure of the surplus

determined by the excess of liabilities over

assets.

Markets contribute to the ALM problem by being

concerned with the economic expansions and

recessions that translate to Bullish and Bearish

markets and thus Markowitz portfolio models

can be applied to the portfolio of assets and

liabilities including popular regime switching

models that identify expansion and recession

modes and equally subject to strategic

imperatives and may include to that extent game

theoretic solutions of incomplete information

and solutions remain Markovian with a memoryless property

Continuous time Markowitz Mean Variance

implementations have been accepted as a

System of Stochastic Differential Equations with

the martingale property implementation with

Geometric Brownian Motion processes for asset

returns, first attributed to Lieppold (2004)

Sharpe and Tint(1990) applied MV optimization

in the static setting to the ALM problem at first.

The recent coverage of economics and markets

linkages has confirmed that upturns follow or

lead bullish periods and downturns follow or

lead bearish periods. All Markov models

including traditional Mean Variance

Optimization portfolios can thus be modified for

a different ALM for bullish periods and bearish

periods This follows the work of Hardy(2001) and

Henderson and Quandt(1958) showing the

superiority of regime switching models in

Maximum likelihood maximization. Chen and

Yang(2014) apply the Asset – Liabilities = Surplus

Management model with uncontrollable

liabilities; assuming n+1 securities and a Markov

Chain. However Hardy and ibid follow an

extended framework including insurance

companies and thus include equities as assets for

the ALM procedure

Rutkauskas(2006) consider the problem of

liquidity and perfect ALM for a commercial bank.

and we recommend their literature review for

this section

Building on the first Linear programming and

Goal programming models, most notably the

Chamber and Charnes(1961) model, their review

sees the coming together of extended

simulations including Grubman(1987) and then

on to stochastic modeling using the above

Markowitz frameworks by Pyle (1971) which however does not balance assets and liabilities

Brodt(1978) created a MV model that optimized

profits and the third approach used in banking

literature includes chance constrained models


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by Charnes et al (1968) and Pogue(1972) with a 12 period chance constrained model

The fourth approach highlighted in Rutkauskas is

a decision theoretic approach proposed by Wolf

(1969) The Bradley and Crane (1972) model is

based on the same. Eppen and Fama (1971)

concretized a fifth dynamic programming

approach whence the literature returns to

stochastic linear programming including the

Russell Yasuda Kasai model by Crane etal(1994)

Thus an amalgamated approach is used in ibid.

involving multiple objectives portfolio efficiency,

feasible risk and guarantee and utility

frameworks to meet objectives of liquidity,

solvency and average yield of assets and

liabilities solved with goal programming (the Integrated ALM perspective)

Sovereign Debt portfolios

Before we move on to our main propositions

based on the environment and the literature on

ALM, we must additionally include focus on

Central Bank ALM. One such research that

focuses on Sovereign debt portfolios is

Papaioannou(2011) basedon the IMF’s observed

denoument of the crises from unbalanced debt

portfolios , outlining normal recourse such as

debt swaps and buybacks available to a

sovereign and/or a Central Bank in managing the

unbalanced debt positions and the liquidity concerns of nations

In non-crisis conditions, Liability management by

itself focusses on financial operations to

maximize the utility of the debt profile with

better terms on existing debt and a sustainable

medium debt maturity profile. In crises

conditions this desk additionally handles debt

restructurings to provide an adequately finance

debt program with at least medium term

viability

Thus debt managers are involved even at the

sovereign level in managing: (1) market risk from

interest rates movements and exchange rate

volatility (2) refinancing risk near maturity (3)

liquidity risk including the availability of

sufficient demand for the debt to avoid price

distortion (4) credit risk as determined by its

credit rating and /or the sovereign’s ability to or

willingness to fulfil its obligations, its Credit

Default Spreads and the Contingent Claims

approach and 95) operational risk covering

financial markets and their technology and settlement procedures

Risk measures remain the same in terms of

symmetrical and quantile measures like

Variance, S.D. and VaR quantiles from a broader

class of Lower Partial Moments gleaned by the author from risk literature

Sovereign liability management underlines the

need to identify ALM as an art and it cannot be

defined as a nuts and bolts or well-structured

policy area. Sovereign debt managers much like

bank debt managers rely on extensive

networking and debt swapping during favorable

market conditions and /or anticipated breaches

of risk thresholds

As a sovereign debt manager one I s also

concerned with a calendared and predictable

national financing program with transparent

auction programs and authorized dealers

Markets also expect defined policies of debt

swaps and buybacks. While paying down debt

care must be taken when shorter maturity debt

is swapped out for longer maturity to be

balanced with buybacks of longer term debt as well (ibid)

Current business challenges for

Commercial Banks and the

pressures on ALM Based on the above literature review, one might

note the forced casualty in managing ALM

operations, emanating initially from its broader


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impact on the confidence in the banks’

operations and that of entire nations, but

divergent schools of thinking even in developed

markets and a sometimes myopic non

recognition of the concurrent impact of active

ALM on Credit & Operational risk , liquidity,

profitability as well as mitigation of interest rate

and exchange rate risks on the banks’ balance

sheets. The critical role of treasury in banks

operations between the Corporate Lending and

Retail banking businesses, between liquidity

provision services of the bank including

Transaction Banking and the non-fund based

advisory services that standalone may not

immediately be available to mitigate the impact

of asynchronous ALM, assert and impact

manifestation of any short medium or long term bank strategy.

Ensuring the deployment of Statutory Bank

reserves may be one starting point for the need

for ALM to manifest itself at the bank. However,

it seems more germaine to consider all the

moving parts and draw up an integrated strategy

for ALM in the bank especially in the current

environment. In terms of techniques there are

advantages of balancing your exposure on a

duration based matching with multiple

objectives of liquidity, profitability and

sensitivity to both credit and operational risks

While systemization has been indelibly

introduced the lack of credit monitoring or

restructuring systems continues to plague

lending margins.

The issue of bank profitability is further clouded

by a global rising rate environment in the latter

part of this decade interspersed by Central bank

injected swathes of sub normal interest rates

and liquidity driven flows to India and other parts

of Asia, LatAm, East Europe and Africa. The issue

of Non-performing loans is likely to come back to

us once this cycle is completed in 2016. Apart

from longer term pressures on recapitalization

from public and private Financial markets this

means more immediate active concerns for the

integrated objectives of a bank’s ALM’;s program

especially without sacrificing larger liquidity

needs of a high growth environment concurrent

with the current positive phase of the Business

cycle

Bank interest margins have been driven down

for a decade and the prior decades largely

dormant PSB ALM strategy of leaving a surplus

position in duration between Assets and

Liabilities has already proved too costly for banks as evidenced by Das and Ghosh(2007)

In the meantime significant regulatory moves

like freeing up of deposit rates hardly had any

impact on ALM in the wake of stable deposit rate

environments, but the new inflation targeting

policy environment may drive India’s nominal

GDP growth and longer term credit growth

measures also down and reduce avenues for

profitable lending. There is in fact a dearth of

rated Principals approaching the banks for

lending and the propensity of high risk SME loans

may make ALM a murkier practice for the Bank

Treasury teams especially with hidden

challenges to liquidity in thinly traded Indian debt markets.

Effective maturity management at the bank

requires a sensitized interest rate forecast that

takes into account the possible variations in the

forecast and limits on the amount at risk in

moves in the opposite direction rather than

depend on recapitalization from the

government. This maturity management takes

into account the primacy of deposit liabilities

and lending assets but also considers investment

horizons and the risk management policies and

exposure of the bank. While the primary bank

strategy may not be initiated by the ALM unit or

the Treasury function it refers to, yet the RARCO

allocation of capital is mapped to its Treasury

and the ALM function integrates an effective

profitability strategy for the bank only if it gives


10

due weight to risk management at each function and unit levels and aggregates the same

Similarly the liquidity objective will have key

constraints not in terms of regulatory capital

which may be more than usually achievable but

to manage the issuance and duration/horizon of

the new debt in lieu of the old debt being

swapped/exchanged. Again as mentioned

earlier reliance on passivity in riding the yield

curve or in pursuing the carry trade servicing

long term assets with liquid short term deposits

may need to be assessed continuously with

simulation and goal programming exercises and

in light of sensitivity to changes in interest rate and exchange rate risks

Investment maturity strategies available even to

small and large sized banking firms include the

less intervention intensive spaced maturity

policy after the decision on average maturity of

securities to hold in the investment portfolio

both in Available for Sale and Held to Maturity

segments These strategies may be spaced

maturity or ladder strategies, Front end loaded

maturity policy or back end loaded maturity

policy. It can be gleaned from Financial intuition

that the back end policy will be more favorable if

rates are expected to fall and vice versa and that

the investment policy itself is not immune to

even parallel shifts of the interest rate term

structure. A financial institution that goes in for

a fully optimized rate expectation approach

implies its readiness and requirement on its part

to actively manage the strategy as he could be

caught holding short term securities in a rising

rate environment instead. The Bar bell strategy

similarily provides for liquidity at the short end

and income from the designated long term

portfolio but is susceptible to moves in the

interest rate term structure than a n investment portfolio of intermediate maturities

For banks holding mortgages and other retail

securities an important risk to be considered in

deciding the ALM / investment strategy is to

what extent to provide for prepayment risk of

retail assets and exactly what term and value to

hold in the liquidity portfolio which will be sold

when liquidity because of deposits or because of

asset demand is required or because of put

options on issued debt and call options on investments

The quality of collateral held against loan assets

and repo transactions is also critical for banks

while current regulation measures have added

limits on inter-bank exposure to the extent of 15%

Banks can now actively choose between Asset

liquidity and Borrowed liquidity management

(Liability management) rather than stay fixed on

one side of the coin. Borrowed liability

management one guesses may be a costly

exercise for a bank known to be a borrower for

liquidity purposes and similarly asset liquidity

may be a critical measure of the efficacy of the

Asset Liquidity management approach for the

liquidity segment of the banking firm’s ALM

strategy. Another traditionally robust approach

to liquidity management that is amenable to

monitoring and quantitative and qualitative

professional execution is the structure of funds

approach which uses a trifold structure of

liabilities in volatile liabilities that require 95% of

liquidity including reserve bank borrowings, the

proportion of the traditional deposits or

Vulnerable funds and the core deposits. While

30% may be provided for Vulnerable deposits,

traditionally only 15 per cent liquidity is provided

to core deposits. On the liquidity management

front each challenge can be monitored using

simple traditional indicators including the ratio

of Reserve bank repos and reverse repos,

Capacity for net loans and leases (vs total assets)

Cash and Hot money (volatile funds ) ratios and others including unutilized commitments.

We are already operating in a completely

deregulated rates environment, but challenges

on the capital convertibility front or monetary


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and fiscal stresses from foreign exchange policies

and monetary and fiscal stances of neighbors

and larger trade partners like China and the US

can become significant concerns for the

economy as a whole but will be a primary front

for ALM desks that need to be sensitized to such

scenarios and policy changes in light of the

exceedingly precarious position with non-

performing assets and core spreads in PSBs.

Indian PSBs are today free to proactively choose

an ALM stance that works for them and are

continuously challenged by the competition and

the accountability forced by public Financial

markets to actively pursue a chosen ALM

strategy with both their eyes open and proven

potential to create profits on a long term basis

for the bank.

The new pressures of evolving micro finance,

Real estate and NBFC lending as financial

services spread because of the availability of

technology build on the banks’ access to low cost

retail and other deposits to pursue a more active

ALM strategy with avenues for liquidity and

investment across a chosen maturity profile while meeting challenges of liquidity

Traditional market shares of Public sector banks

are also likely to be challenged by the presence

of efficient private sector players equipped with

better talent and pay for performance /quality of

life initiatives that convert into a more active and

monitored ALM and even shared access to

regulators with limited avenues to influence the

state to support their profitability with instant

regulatory estoppels and continuing regulatory delays in redressal of uneven playing fields.

Focus on infrastructure financing may further

reduce the role of banks in the guise of shadow

banking institutions and foreign capital access as

well as ALM measures required to measure up to

25 year maturity horizon assets if they grow to

their optimum size including the example of

China’s larger state owned banks and their

experience with local governments and SOEs in debt assets

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