Asset Liability Management in Banks

Components of a Bank Balance Sheet

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 ALM ALM information systemsALM OrganizationALM 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 ParametersRisk IdentificationRisk MeasurementRisk ManagementRisk Policies and Tolerance Level

Categories of Risk  Risk is the chance or probability of loss or damage Credit RiskMarket RiskOperational Risk Transaction Risk /default risk /counterparty risk Commodity riskProcess risk Portfolio risk /Concentration risk Interest Rate riskInfrastructure risk Settlement riskForex rate riskModel risk Equity price riskHuman 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 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 Liquidity All 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

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 Interest Rate Risk BasisRe-pricingYieldOptions

 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

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