ASSET LIABILITY MANAGEMENT (ALM)

History of bank failures in US

Components of a Bank Balance sheet LiabilitiesAssets 1.Capital 2.Reserve & Surplus 3.Deposits 4.Borrowings 5.Other Liabilities 1.Cash & Balances with RBI 2.Bal. With Banks & Money at Call and Short Notices 3.Investments 4.Advances 5.Fixed Assets 6. Other Assets Contingent Liabilities

Business Risks Operational Risk Credit Risk Market Risk Liquidity Risk Interest Rate Risk Foreign Exchange Risk Information Risk

What is ALM ?... Concerned with strategic Balance Sheet management Concerned with strategic Balance Sheet management Match between assets and liabilities in BS Match between assets and liabilities in BS Risks stem from mismatch between A&L – credit, liquidity, interest, currency Risks stem from mismatch between A&L – credit, liquidity, interest, currency ALM is not to avoid risk but to manage risk, sustaining profitability ALM is not to avoid risk but to manage risk, sustaining profitability

What is ALM ?...contd.. Periodic monitoring of risk exposures involving collecting and analysing information Periodic monitoring of risk exposures involving collecting and analysing information Ability to anticipate, forecast and act so as to structure bank’s business to profit Ability to anticipate, forecast and act so as to structure bank’s business to profit Altering A & L portfolio in a dynamic way to manage risks Altering A & L portfolio in a dynamic way to manage risks Involves judgement and decision making Involves judgement and decision making

Defining ALM ALM involves Planning, directing and Controlling the flow, mix, cost and yield of the consolidated funds of bank ALM involves Planning, directing and Controlling the flow, mix, cost and yield of the consolidated funds of bank Assesses various asset mixes, funding combinations, price volume relations and their implications on Liquidity, Income and Capital ratio Assesses various asset mixes, funding combinations, price volume relations and their implications on Liquidity, Income and Capital ratio Planning procedure which accounts for all assets and liabilities of a bank by rate, amount and maturity Planning procedure which accounts for all assets and liabilities of a bank by rate, amount and maturity

Why ALM ? Banks exposed to credit and market risks in view of asset-liability transformation Banks exposed to credit and market risks in view of asset-liability transformation Risks increased with liberalisation and growing integration of domestic markets with external markets Risks increased with liberalisation 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 Banks now operate in deregulated environment and are required to determine interest rates on various products

Why ALM ?.. Contd.. Need to maintain balance among spread, profitability and long-term viability Need to maintain balance among spread, profitability and long-term viability Increasing volatility in domestic interest rates as well as foreign exchange rates Increasing volatility in domestic interest rates as well as foreign exchange rates New financial product innovation New financial product innovation

Why ALM ?.. Contd.. Increased level of awareness among top management - market risks, interest rate movements Increased level of awareness among top management - market risks, interest rate movements Intense competition for business involving both assets and liabilities Intense competition for business involving both assets and liabilities

Why ALM ?.. Contd.. Regulatory initiatives Regulatory initiatives International initiative – Basle Committee International initiative – Basle Committee Thus, a call for structured and comprehensive measures for institutionalising an integrated risk management system Thus, a call for structured and comprehensive measures for institutionalising an integrated risk management system

Overall Objective.. The central theme of (ALM) is the management of a bank’s entire balance sheet on continuous basis with a view to ensure a proper balance between funds mobilisation and their deployment with respect to their maturity profiles, cost and yield as well as risk exposure so as to improve profitability, ensure adequate liquidity, manage risks and ensure long term viability The central theme of (ALM) is the management of a bank’s entire balance sheet on continuous basis with a view to ensure a proper balance between funds mobilisation and their deployment with respect to their maturity profiles, cost and yield as well as risk exposure so as to improve profitability, ensure adequate liquidity, manage risks and ensure long term viability

RBI / NABARD Guidelines on ALM Draft guidelines issued on 10 Sept 1998 Draft guidelines issued on 10 Sept 1998 Final guidelines issued on 10 Feb 1999 for implementation from 1 April 1999 Final guidelines issued on 10 Feb 1999 for implementation from 1 April 1999 At least 60% of assets and liabilities to be covered initially At least 60% of assets and liabilities to be covered initially 100% coverage from 1 April % coverage from 1 April 2000

RBI / NABARD Guidelines on ALM NABARD guidelines on Risk Management Systems in Banks – April 2005 NABARD guidelines on Risk Management Systems in Banks – April 2005 Guidelines were issued to 5 select State Cooperative Banks viz. Andhra Pradesh, Tamil Nadu. Maharashtra. Punjab and West Bengal SCBs and 12 selected RRBs for implementation of Asset - Liability Management (ALM) System wef so far satisfactory. Guidelines were issued to 5 select State Cooperative Banks viz. Andhra Pradesh, Tamil Nadu. Maharashtra. Punjab and West Bengal SCBs and 12 selected RRBs for implementation of Asset - Liability Management (ALM) System wef so far satisfactory.

RBI / NABARD Guidelines on ALM BOS Meeting decided introduction of ALM in all the SCBs & RRBs wef BOS Meeting decided introduction of ALM in all the SCBs & RRBs wef ALM to be introduced in phased manner in DCCBs. ALM to be introduced in phased manner in DCCBs. Initially selected 31 DCCBs for ALM wef Initially selected 31 DCCBs for ALM wef Interim target to cover 100% business by Interim target to cover 100% business by

RBI / NABARD Guidelines on ALM Once system stabilises, bank gain experience- swtch over to sophisticated computerised techniques –Duration Gap analysis, Simulation & VaR for Interest rate risk management Once system stabilises, bank gain experience- swtch over to sophisticated computerised techniques –Duration Gap analysis, Simulation & VaR for Interest rate risk management

RBI / NABARD Guidelines on ALM Review of computerisation in bank Review of computerisation in bank Suitability of manpower –implementation Suitability of manpower –implementation ALM policy approved by BOD ALM policy approved by BOD Constitute ALCO to review ALM implementation in bank Constitute ALCO to review ALM implementation in bank Start generating reports as required Start generating reports as required Capacity building (KM) of nodal officer Capacity building (KM) of nodal officer Upgrade MIS for preparation of reports Upgrade MIS for preparation of reports Send detailed monthly progress reports- present status, progress made & action plan for future Send detailed monthly progress reports- present status, progress made & action plan for future

ALM Process- Three pillars ALM Information System ALM Information System Management Information System Management Information System Information availability, accuracy, adequacy and expediency Information availability, accuracy, adequacy and expediency ALM Organisation ALM Organisation Structure and responsibilities Structure and responsibilities Level of top management involvement Level of top management involvement ALM Process ALM Process Risk parameters, risk identification, risk measurement, risk management, risk policies and procedures, prudential limits & auditing, reporting & review Risk parameters, risk identification, risk measurement, risk management, risk policies and procedures, prudential limits & auditing, reporting & review

ALM Information Systems Information is the key to the ALM process Information is the key to the ALM process Varied business profiles – no uniform ALM system for all banks Varied business profiles – no uniform ALM system for all banks Methods range from simple Gap statement to extremely sophisticated simulation methods. Methods range from simple Gap statement to extremely sophisticated simulation methods. Availability of adequate, timely and accurate information, the central element for ALM exercise Availability of adequate, timely and accurate information, the central element for ALM exercise

ALM Information Systems-Challenges Large network of branches and lack of an adequate support system to collect information Large network of branches and lack of an adequate support system to collect information Problem to be addressed through ABC approach – atleast 60-70% of total business- analysing behaviour of assets and liabilities in sample branches Problem to be addressed through ABC approach – atleast 60-70% of total business- analysing behaviour of assets and liabilities in sample branches Investment portfolio – easy since centralised Investment portfolio – easy since centralised Spread of computerisation helps Spread of computerisation helps

ALM Organisation Board to have overall responsibility and frame risk management policy Board to have overall responsibility and frame risk management policy Board to set limits for liquidity, interest rate and exchange rate risks Board to set limits for liquidity, interest rate and exchange rate risks ALCO (Asset Liability Committee) consisting of senior management including CEO decides strategy and adheres to objective ALCO (Asset Liability Committee) consisting of senior management including CEO decides strategy and adheres to objective ALM Support Groups, responsible for analysing, monitoring and reporting the risk profiles to ALCO ALM Support Groups, responsible for analysing, monitoring and reporting the risk profiles to ALCO Staff also prepare the forecasts (simulations) showing effects and recommend action Staff also prepare the forecasts (simulations) showing effects and recommend action

ALCO-responsibilities ALCO decision making unit- Responsible for balance sheet planning from risk return perspective 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 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 Articulating the current interest rate view and a view on future direction of interest rate movements

ALCO-responsibilities Deciding the business strategy of the bank, consistent with the interest rate view, budget and pre- determined risk management objectives Deciding the business strategy of the bank, consistent with the interest rate view, budget and pre- determined risk management objectives Determining the desired maturity profile and mix of assets and liabilities Determining the desired maturity profile and mix of assets and liabilities

ALCO-responsibilities.. contd.. Product pricing for both assets and liabilities side Product pricing for both assets and liabilities side Deciding the funding strategy i.e. source and mix of liabilities or sale of assets Deciding the funding strategy i.e. source and mix of liabilities or sale of assets Reviewing implementation of decisions made in the previous meeting Reviewing implementation of decisions made in the previous meeting

Composition of ALCO The size of ALCO depends on size of institution, business mix and organisational complexity The size of ALCO depends on size of institution, business mix and organisational complexity CEO to head the Committee CEO to head the Committee Chiefs of Investment, Credit, Resource Management, Funds Management/ Treasury, Banking and Economic Research to be members of the Committee Chiefs of Investment, Credit, Resource Management, Funds Management/ Treasury, Banking and Economic Research to be members of the Committee

Composition of ALCO…. Head of Technology Division be an invitee Head of Technology Division be an invitee Some banks may have sub-committees and support groups Some banks may have sub-committees and support groups Management committee to oversee and review Management committee to oversee and review

ALM Process Scope of ALM function can be defined as:  Liquidity Risk Management  Interest rate risks management  Trading risk management  Funding and capital planning  Profit planning and growth projection  RBI guidelines mainly cover Liquidity and Interest rate risks

Policy for creation of liabilities An appropriate policy for creation of liabilities has to take care that: Adequate financial resources (i.e.funds) are mobilised keeping in view the bank’s deployment requirements Adequate financial resources (i.e.funds) are mobilised keeping in view the bank’s deployment requirements The cost of liabilities in terms of interest cost is least and is reduced from time to time The cost of liabilities in terms of interest cost is least and is reduced from time to time

Policy for creation of liabilities The servicing / operational cost of the liabilities is kept low with emphasis on volumes The servicing / operational cost of the liabilities is kept low with emphasis on volumes The liabilities should come from fairly diversified sources so that set backs in one area do not affect the overall financial resource position The liabilities should come from fairly diversified sources so that set backs in one area do not affect the overall financial resource position

Policy for creation of assets An appropriate policy for creation of assets has to aim at: Making provisions for meeting statutory requirements like reserves-CRR, SLR Making provisions for meeting statutory requirements like reserves-CRR, SLR Maximising of the yield or return on various components of assets Maximising of the yield or return on various components of assets Maintenance of adequate liquidity through appropriate mix of assets Maintenance of adequate liquidity through appropriate mix of assets

Policy for creation of assets… Diversification of assets so as to minimise losses Diversification of assets so as to minimise losses Lending advances with prudence based on risk perception with the sole objective that it should not turn out to be non-performing Lending advances with prudence based on risk perception with the sole objective that it should not turn out to be non-performing

Liquidity Risk Management Assured ability to meet its liabilities as they become due reduces the probability of an adverse situation developing Assured ability to meet its liabilities as they become due reduces the probability of an adverse situation developing Liquidity shortfall in one institution can have repercussions on the entire system Liquidity shortfall in one institution can have repercussions on the entire system

Liquidity Risk Management…. Assets commonly considered as liquid like Government securities and other money market instruments could also become illiquid when the market and players are unidirectional Assets commonly considered as liquid like Government securities and other money market instruments could also become illiquid when the market and players are unidirectional Liquidity has to be tracked through maturity or cash flow mismatches Liquidity has to be tracked through maturity or cash flow mismatches Use of maturity ladder – standard tool Use of maturity ladder – standard tool

Statement of structural liquidity

Time buckets for maturity profile i days ii days iii. 29 days and upto 3 months iv. Over 3 months and upto 6 months v. Over 6 months and upto 1 year vi. Over 1 year and upto 3 years vii. Over 3 years and upto 5 years viii. Over 5 years

Liquidity mismatches… contd.. The mismatches during 1-14 & days not to exceed 20% of cash outflows The mismatches during 1-14 & days not to exceed 20% of cash outflows Maturing liability is a cash outflow and maturing asset is a cash inflow Maturing liability is a cash outflow and maturing asset is a cash inflow Tolerance level in mismatches to be determined based on asset-liability base, nature of business, future strategy etc. Tolerance level in mismatches to be determined based on asset-liability base, nature of business, future strategy etc. Banks to monitor their short term liquidity on a dynamic basis over a time horizon spanning from 1-90 days (short term dynamic liquidity statement) Banks to monitor their short term liquidity on a dynamic basis over a time horizon spanning from 1-90 days (short term dynamic liquidity statement)

Estimation of short term dynamic liquidity

Interest Rate Risk Interest rate risk is the risk where changes in the market interest rates might adversely affect a bank’s financial condition Interest rate risk is the risk where changes in the market interest rates might adversely affect a bank’s financial condition Immediate impact would be on bank’s earnings by changing its NII Immediate impact would be on bank’s earnings by changing its NII Long tem impact of changing interest rates would be on bank’s Net Worth Long tem impact of changing interest rates would be on bank’s Net Worth Interest rate risk is measured in terms of change in NII Interest rate risk is measured in terms of change in NII

Interest Rate Risk… Traditional Gap analysis method is to be used now Traditional Gap analysis method is to be used now Move over to modern techniques of Interest Rate Risk measurement like Duration Gap analysis, simulation, VAR gradually Move over to modern techniques of Interest Rate Risk measurement like Duration Gap analysis, simulation, VAR gradually Gap or Mismatch analysis measures gaps between rate sensitive assets and rate sensitive liabilities Gap or Mismatch analysis measures gaps between rate sensitive assets and rate sensitive liabilities

Interest Rate Risk-measurement An asset or liability is considered rate sensitive if: An asset or liability is considered rate sensitive if: Within the time interval under consideration there is a cash flow Within the time interval under consideration there is a cash flow the interest rate resets/reprises contractually during the period the interest rate resets/reprises contractually during the period RBI changes the interest rates RBI changes the interest rates It is contractually pre-payable or withdrawable before the stated maturity It is contractually pre-payable or withdrawable before the stated maturity

Interest rate sensitivity - Reporting format

Interest Rate Risk-measurement Gap report is generated by grouping the RSA, RSL into time buckets according to residual maturity or next reprising period, whichever is earlier. Gap report is generated by grouping the RSA, RSL into time buckets according to residual maturity or next reprising period, whichever is earlier. All investments, advances, deposits, borrowings, purchased funds etc that mature/reprise within a specified timeframe are interest rate sensitive All investments, advances, deposits, borrowings, purchased funds etc that mature/reprise within a specified timeframe are interest rate sensitive

Rate sensitive assets and liabilities

Interest Rate Risk-Gap in time buckets The gaps may be identified in the following time buckets The gaps may be identified in the following time buckets i days ii. 29 days and upto 3 months iii. Over 3 months and upto 6 months iv. Over 6 months and upto 1 year v. Over 1 year and upto 3 years vi. Over 3 years and upto 5 years vii. Over 5 years viii. Non-sensitive

Interest Rate Risk – Gap report The gap is the difference between RSA and RSL for each time bucket The gap is the difference between RSA and RSL for each time bucket RSA>RSL - positive gap RSA>RSL - positive gap RSA<RSL - negative gap RSA<RSL - negative gap Positive – beneficial with rising rates Positive – beneficial with rising rates Negative – beneficial with declining rates Negative – beneficial with declining rates Each bank should set prudential limits on individual gaps with the approval of the Board/Management Committee Each bank should set prudential limits on individual gaps with the approval of the Board/Management Committee

General…. Classification of various components of assets and liabilities into different time buckets made is benchmark Classification of various components of assets and liabilities into different time buckets made is benchmark Better equipped banks may reclassify based on data/studies subject to approval of ALCO/Board Better equipped banks may reclassify based on data/studies subject to approval of ALCO/Board Note approved by ALCO/Board to be sent to RBI Note approved by ALCO/Board to be sent to RBI

Summary…. Coordinated financial management of BS Coordinated financial management of BS Risk by choice and not by chance Risk by choice and not by chance A pulse on approach to market risk management A pulse on approach to market risk management Increased awareness of market risks Increased awareness of market risks Both science and an art Both science and an art

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