Presentation by K P Gwachha, Faculty Member, SAINIK College Asset Liability Management in Banks Presentation by K P Gwachha, Faculty Member, SAINIK College

Components of a Bank Balance sheet Liabilities Assets Capital Reserve & Surplus Deposits Borrowings Other Liabilities Cash & Balances with RBI Bal. With Banks & Money at Call and Short Notices Investments Advances Fixed Assets 6. Other Assets Contingent Liabilities

Components of Liabilities Capital: Capital represents owner’s contribution/stake in the bank. It serves as a cushion for depositors and creditors. It is considered to be a long term sources for the bank.

Components of Liabilities 2. Reserves & Surplus Components under this head includes: I. Statutory Reserves II. Capital Reserves III. Investment Fluctuation Reserve IV. Revenue and Other Reserves V. Balance in Profit and Loss Account

Components of Liabilities 3. Deposits This is the main source of bank’s funds. The deposits are classified as deposits payable on ‘demand’ and ‘time’. They are reflected in balance sheet as under: I. Demand Deposits II. Savings Bank Deposits III. Term Deposits

Components of Liabilities 4. Borrowings (Borrowings include Refinance / Borrowings from NRB, Inter-bank & other institutions) I. Borrowings in Nepal i) Nepal Rastra Bank ii) Other Banks iii) Other Institutions & Agencies II. Borrowings outside Nepal

Components of Liabilities 5. Other Liabilities & Provisions It is grouped as under: I. Bills Payable II. Inter Office Adjustments (Net) III. Interest Accrued IV. Unsecured Redeemable Bonds (Subordinated Debt for Tier-II Capital) V. Others(including provisions)

Components of Assets Cash & Bank Balances with NRB I. Cash in hand (including foreign currency notes) II. Balances with Nepal Rastra bank In Current Accounts In Other Accounts

Components of Assets 2. BALANCES WITH BANKS AND MONEY AT CALL & SHORT NOTICE I. In Nepal i) Balances with Banks a) In Current Accounts   b) In Other Deposit Accounts ii) Money at Call and Short Notice a) With Banks   b) With Other Institutions II. Outside Nepal b) In Other Deposit Accounts c) Money at Call & Short Notice

Components of Assets 3. Investments A major asset item in the bank’s balance sheet. Reflected under 6 buckets as under: I. Investments in Nepal in : * i) Government Securities ii) Other approved Securities iii) Shares iv) Debentures and Bonds v) Subsidiaries and Sponsored Institutions vi) Others (UTI Shares , Commercial Papers, COD & Mutual Fund Units etc.) II. Investments outside Nepal in **   Subsidiaries and/or Associates abroad

Components of Assets 4. Advances The most important assets for a bank. A. i) Bills Purchased and Discounted ii) Cash Credits, Overdrafts & Loans repayable on demand iii) Term Loans B. Particulars of Advances : i) Secured by tangible assets (including advances against Book Debts) ii) Covered by Bank/ Government Guarantees iii) Unsecured

Components of Assets 5. Fixed Asset 6. Other Assets I. Premises II. Other Fixed Assets (Including furniture and fixtures) 6. Other Assets I. Interest accrued   II. Tax paid in advance/tax deducted at source (Net of Provisions)   III. Stationery and Stamps   IV. Non-banking assets acquired in satisfaction of claims   V. Deferred Tax Asset (Net)  VI. Others

Contingent Liability Bank’s obligations under LCs, Guarantees, Acceptances on behalf of constituents and Bills accepted by the bank are reflected under this heads.

Banks Profit & Loss Account A bank’s profit & Loss Account has the following components: Income: This includes Interest Income and Other Income. II. Expenses: This includes Interest Expended, Operating Expenses and Provisions & contingencies.

Components of Income INTEREST EARNED I. Interest/Discount on Advances / Bills  II. Income on Investments  III. Interest on balances with NRB and other inter-bank funds  IV. Others

Components of Income 2. OTHER INCOME I. Commission, Exchange and Brokerage II. Profit on sale of Investments (Net) III. Profit/(Loss) on Revaluation of Investments IV. Profit on sale of land, buildings and other assets (Net) V. Profit on exchange transactions (Net) VI. Income earned by way of dividends etc. from subsidiaries and Associates abroad/in India VII. Miscellaneous Income

Components of Expenses INTEREST EXPENDED I. Interest on Deposits II. Interest on Reserve Bank of India / Inter-Bank borrowings III. Others

Components of Expenses 2. OPERATING EXPENSES I. Payments to and Provisions for employees II. Rent, Taxes and Lighting  III. Printing and Stationery IV. Advertisement and Publicity  V. Depreciation on Bank's property VI. Directors' Fees, Allowances and Expenses  VII. Auditors' Fees and Expenses (including Branch Auditors)  VIII. Law Charges   IX. Postages, Telegrams, Telephones etc.   X. Repairs and Maintenance   XI. Insurance  XII. Other Expenditure

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

Assets Liability Management ALM Assets Liability Management It is a dynamic process of Planning, Organizing & Controlling of Assets & Liabilities- their volumes, mixes, maturities, yields and costs in order to maintain liquidity and NII.

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.

Purpose & Objective of ALM 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 ration. 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

Why ALM ? Banks exposed to credit and market risks in view of asset-liability transformation Risks increased with liberalization and growing integration of domestic markets with external markets Banks now operate in deregulated environment and are required to determine interest rates on various products Need to maintain balance among spread, profitability and long-term viability Increasing volatility in domestic interest rates as well as foreign exchange rates New financial product innovation

Why ALM ?.. Contd.. Increased level of awareness among top management - market risks, interest rate movements Intense competition for business involving both assets and liabilities Regulatory initiatives International initiative – Basle Committee Thus, a call for structured and comprehensive measures for institutionalizing an integrated risk management system

3 tools used by banks for ALM ALM information systems ALM Organization ALM Process

ALM Information Systems Usage of Real Time information system to gather the information about the maturity and behavior of loans and advances made by all other branches of a bank ABC Approach : analysing the behaviour of asset and liability products in the top branches as they account for significant business then making rational assumptions about the way in which assets and liabilities would behave in other branches The data and assumptions can then be refined over time as the bank management gain experience The spread of computerisation will also help banks in accessing data.

ALM Organization The board should have overall responsibilities and should set the limit for liquidity, interest rate, foreign exchange and equity price risk The Asset - Liability Committee (ALCO) ALCO, consisting of the bank's senior management (including CEO) should be responsible for ensuring adherence to the limits set by the Board Is responsible for balance sheet planning from risk - return perspective including the strategic management of interest rate and liquidity risks The role of ALCO includes product pricing for both deposits and advances, desired maturity profile of the incremental assets and liabilities, It will have to develop a view on future direction of interest rate movements and decide on a funding mix between fixed vs floating rate funds, wholesale vs retail deposits, money market vs capital market funding, domestic vs foreign currency funding It should review the results of and progress in implementation of the decisions made in the previous meetings

Risk Policies and Tolerance Level 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 damage Credit 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 Funding risk Time risk Call Risk Liquidity risk arises from funding of long term assets by short term liabilities, thus making the liabilities subject to refinancing Funding risk Arises due to unanticipated withdrawals of the deposits from wholesale or retail clients Time risk It arises when an asset turns into a NPA. So, the expected cash flows are no longer available to the bank. Call Risk Due to crystallisation of contingent liabilities and unable to undertake profitable business opportunities when available.

Liquidity 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 New loan demands, existing commitments, and deposit withdrawals are the basic contractual or relationship obligations that a bank must meet.

Adequacy of liquidity position for a bank Analysis of following factors throw light on a bank’s adequacy of liquidity position: Historical Funding requirement Current liquidity position Anticipated future funding needs Sources of funds Options for reducing funding needs Present and anticipated asset quality Present and future earning capacity and h. Present and planned capital position

Funding Avenues To satisfy funding needs, a bank must perform one or a combination of the following: Dispose off liquid assets Increase short term borrowings Decrease holding of less liquid assets Increase liability of a term nature e. Increase Capital funds

Types of Liquidity Risk Liquidity Exposure can stem from both internally and externally. External liquidity risks can be geographic, systemic or instrument specific. Internal liquidity risk relates largely to perceptions of an institution in its various markets: local, regional, national or international

Other categories of liquidity risk Funding Risk - Need to replace net outflows due to unanticipated withdrawals/non-renewal Time Risk - Need to compensate for non-receipt of expected inflows of funds Call Risk - Crystallization of contingent liability

Statement of Structural Liquidity All Assets & Liabilities to be reported as per their maturity profile into 8 maturity Buckets: 1 to 14 days 15 to 28 days 29 days and up to 3 months Over 3 months and up to 6 months Over 6 months and up to 1 year Over 1 year and up to 3 years Over 3 years and up to 5 years 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

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.

STRATEGIES… To meet the mismatch in any maturity bucket, the bank has to look into taking deposit and invest it suitably so as to mature in time bucket with negative mismatch. The bank can raise fresh deposits of Rs 300 crore over 5 years maturities and invest it in securities of 1-29 days of Rs 200 crores and rest matching with other out flows.

Maturity Pattern of Select Assets & Liabilities of A Bank Liability/Assets Rupees (In Cr) In Percentage I. Deposits a. Up to 1 year b. Over 1 yr to 3 yrs c. Over 3 yrs to 5 yrs d. Over 5 years 15200 8000 6700 230 270 100 52.63 44.08 1.51 1.78 II. Borrowings 450 180 00 150 120 40.00 0.00 33.33 26.67 III. Loans & Advances 8800 3400 3000 400 2000 38.64 34.09 4.55 22.72 Iv. Investment 5800 1300 300 900 3300 22.41 5.17 15.52 56.90

SUCCESS OF ALM IN BANKS : PRE - CONDITIONS Awareness for ALM in the Bank staff at all levels–supportive Management & dedicated Teams. Method of reporting data from Branches/ other Departments. (Strong MIS). Computerization-Full computerization, networking. Insight into the banking operations, economic forecasting, computerization, investment, credit. 5. Linking up ALM to future Risk Management Strategies.

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 Management 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 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 Therefore, an effective risk management process that maintains interest rate risk within prudent levels is essential to safety and soundness of the bank.

Sources of Interest Rate Risk Basis Re-pricing Yield Options

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.

Duration Analysis It basically refers to the average life of the asset or the liability It is the weighted average time to maturity of all the preset values of cash flows The larger the value of the duration, the more sensitive is the price of that asset or liability to changes in interest rates 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.

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 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

Asset and liability management committee (ALCO) A bank's asset and liability management committee (ALCO) coordinates all policy decisions and strategies that determine a bank's risk profit and profit objectives. Interest rate risk management is the primary responsibility of this committee.

ALCO - Role & Responsibilities ALCO decision making unit- Responsible for balance sheet planning from risk return perspective Monitoring the market risk levels by ensuring adherence to the various risk limits set by the bank Articulating the current interest rate view and a view on future direction of interest rate movements Deciding the business strategy of the bank, consistent with the interest rate view, budget and pre-determined risk management objectives

ALCO – Role & Responsibilities Determining the desired maturity profile and mix of assets and liabilities Product pricing for both assets and liabilities side Deciding the funding strategy i.e. source and mix of liabilities or sale of assets Reviewing implementation of decisions made in the previous meeting

Composition of ALCO The size of ALCO depends on size of institution, business mix and organizational complexity CEO to head the Committee Chiefs of Investment, Credit, Resource Management, Funds Management/ Treasury, Banking and Economic Research to be members of the Committee Head of Technology Division be an invitee Some banks may have sub-committees and support groups Management committee to oversee and review

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