Asset Liability Management

Risks in Banking Interest rate risk : 2 Risks in Banking Interest rate risk : Risk that arises when the interest income/ market value of the bank is sensitive to the interest rate fluctuations. Credit Risk : Risk that arises due to the possibility of a default/delay in the repayment obligation by the borrowers of funds.

Risks in Banking Liquidity risk : Risk that arises due to the mismatch in the maturity patterns of the assets and liabilities. Treasury management risk : Risk to the banks due to changes in cash flows in its deposit and credit structure that requires an obligation to maintain liquidity.

Risks in Banking Operational risk: Risk arising out of fluctuations in day to day operations of the banks. Market risk: Risk of events reducing the return expectation of bank capital owners.

Risks in Banking Foreign Exchange/Currency Risk: Risk that arises due to unanticipated fluctuation in exchange rates. Contingency risk: Risk that arises due to the presence of off- balance sheet items such as guarantees, letters of credit, underwriting commitments etc.

Interest Rate Risk Management 6 Interest Rate Risk Management Interest rate risk management deals with the possibility that future events could change the return expectation of banks. Risk management provides strategies, techniques, tools and approaches to handle interest rate change implications for banks.

Interest Rate Risk Management Tasks 7 Interest Rate Risk Management Tasks Evaluate the quantum of loss likely to occur due to interest rate change. Organize the structure of banking operations to react to interest rate changes. Balance the risk control mechanism of a bank to manage risk and maintain expected returns. Managing risks by foreseeing the interest rate changes and make informed banking decisions to utilize the opportunities and minimize the threats.

Interest Rate Risk Management Goal 8 Interest Rate Risk Management Goal Maximize bank profits. Creating opportunity out of interest rate risk. Minimize risk and protect the bank assets. Reduce losses arising out of interest rate commitments by banks.

Asset-Liability Management (ALM) 9 Asset-Liability Management (ALM) Asset-liability management considers the effect of bank profits on the overall bank strategy. The nature of capital of banks being small when compared to its asset structure, any change in asset structure is likely to prove detrimental to the bank’s profitability. Banks need to examine the effect of changes in capital to changes in the asset structure simultaneously to enhance overall profits.

Sample Bank Balance Sheet 1010 Sample Bank Balance Sheet Liabilities Assets Capital 20000 Reserves 85000 Borrowings 10000 Advances 588000 Short term deposits 550000 Investments 100000 Long term deposits 200000 Fixed Assets 7000 Total 780000 What if advances value is reduced by 2%? –

1111 What if Advances Value is Reduced by 2%? –Approximately 58.8% Reduction in Capital!!! Liabilities Assets Capital 8240 Reserves 85000 Borrowings 10000 Advances 576240 Short term deposits 550000 Investments 100000 Long term deposits 200000 Fixed Assets 7000 Total 768240

Changes in interest rates Changes in exchange rates 1212 Risks Handled by ALM Core risk Changes in interest rates Changes in exchange rates Changes in liquidity position of the bank Additional risk Credit risk Contingency risk

ALM Risk Management Models 1313 ALM Risk Management Models Asset Models Liability Models Randomness Models Multi-dimensional Models CALM (Computer Aided Asset/ Liability Management) Stochastic Programming Model

Asset Models Analyze risk in terms of bank assets - Advances - Loan syndication - Investments Analyze returns of bank assets - Credit default - Portfolio loss Model determination - Long term / Short term

Liability Models Deposit maturity structure Borrowings management Bond risk management / Immunization of bond portfolios Swap structures for management of interest rate risk Management of liability driven investments

Randomness Models Random parameters - Asset price - Interest rates - Credit default - Deposit flow - Inflation rate - Market price

Multi-Dimensional Models

CALM Stochastic Programming Models Dynamic asset liability management Computer aided applications by banks Optimization decision model based on constraints Uncertainty in terms of asset and liability flows Change in asset and liability classes

Multi-Stage Stochastic Programming First Stage Decision Observation n’th Observation Second Stage Decision n’th Stage Decision

Managing Interest Rate Risk 2020 Managing Interest Rate Risk Manage the volume Manage the mix Manage the maturity Manage the rate sensitivity Manage the quality Manage the liquidity of the assets and liabilities Achievement of a predetermined acceptable risk/reward ratio

Parameters for ALM Net Interest Margin (NIM) : Impact of volatility on the short-term profits is measured by NIM. To stabilize the short-term profits the banks aim at minimizing fluctuations in the NIM.

Market Value of Equity (MVE) : 2222 Parameters for ALM Market Value of Equity (MVE) : The market value of equity represents the long-term profits of the bank. The banks aim at minimizing adverse movement in their market value due to interest rate fluctuations. In the case of unlisted banks, the difference between the market value of assets and liabilities represent the target that is to be achieved by the banks.

Parameters for ALM Economic Equity Ratio : This ratio measures the shifts in the ratio of owned funds to total funds. Evaluates the sustenance capacity of a bank. Economic Equity Ratio =

Managing Bank Risk - A Note by Reserve Bank of India 2424 Managing Bank Risk - A Note by Reserve Bank of India Traditional methods - Operational limits on credit lines - Loan provisioning - Portfolio diversification - Collateralization

RBI Note on Managing Bank Risk - Innovative methods 2525 RBI Note on Managing Bank Risk - Innovative methods Loan securitization Capital adequacy guidelines Derivatives - Swap products - Option products (spread options, sovereign risk options) - Forward Rate Agreements

Prerequisites for Risk Management 2626 Prerequisites for Risk Management A well-developed Repo market Forward trading in securities Revolving Underwriting facilities Introduction of asset-liability based derivatives (Strips and Asset Backed Securities) - Benchmark securities - Fungibility, auction system, settlement procedures and market infrastructure A strong money market