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

2. 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
Other Assets
Contingent Liabilities

3. 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.

4. 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

5. 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

6. 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

7. 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)

8. 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

9. 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

10. 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

11. 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

12. 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

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

14. 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.

15. 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

16. 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

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

18. 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

19. 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

20. 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.

22. 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.

23. 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

24. 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

25. 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

26. 3 tools used by banks for ALM
ALM information systems
ALM Organization
ALM Process

27. 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.

28. 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

29. Risk Policies and Tolerance Level
ALM Process
Risk Parameters
Risk Identification
Risk Measurement
Risk Management
Risk Policies and Tolerance Level

30. 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

32. But under ALM risks that are typically managed are….
Will now be discussed in detail
Interest Rate Risk
Currency Risk
Liquidity Risk

33. 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.

34. 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.

35. 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

36. 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

37. 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

38. 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

39. 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

40. 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.

41. An Example of Structural Liquidity Statement

42. 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.

43. 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.

44. 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

45. 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.

46. 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.

47. 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.

48. 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.

49. Sources of Interest Rate Risk
Basis
Re-pricing
Yield
Options

50. 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.

51. Risk Measurement Techniques
Various techniques for measuring exposure of banks to interest rate risks
Maturity Gap Analysis
Duration
Simulation
Value at Risk

52. 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

53. 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.

54. 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.

55. 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

56. 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

57. 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.

60. 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

61. 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

63. 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

64. THANK YOU