1. ASSET LIABILITY MANAGEMENT

2. Generic Income Statement Of Fin. Inst.
FINANCIAL INSTITUTIONs
INTEREST REVENUE (IR)
-INTEREST EXPENCE (IE)
SPREAD = (IR – IE)
Non interest Expenses
-Non interest Revenues (fee based revenues)
NIE (Net non interest expenses)
EBT = Spread – NIE
TAX NI
DIVIDENDS TO PREFERRED SHARE
INCOME AVAILABLE TO COMMON SHARES
EPS = INCOME TO COMMON SHARE /SHARES
DPS = d * EPS

3. IR= r * TA
IE= c * TL
r = weighted average interest rate (yield) earned on assets
c = weighted average interest rate (yield) paid on liabilities. Cost of funds.
r =[{( Asset1/TA) x r1}+ {( Asset2/ TA ) x r2}+……….+ {(Assetn /TA) x rn}]
c =[{( Liab.1 / TL) xc1} + {(Liab 2 / TL) x c2} +…………..+{(Liab n / TL) x cn}]
IR=( Asset1 x r1 ) + (Asset2 x r2) +……………(.Asset n x rn)
IE = ( Liability1 x c1) + ( Liability2 x c2 )+……………+(Liability n x c n)
NIE is (Net non interest Expenses) = Non Interest expenses - Non Interest Revenues

4. Non Interest Expenses:
Rents, Salaries, utilities, Mkt’g Expenses/Advertising. , Stationary, entertainment.
Depreciation, Insurance of premises and insurance of Deposits, Security guards etc.
Legal expenses, Bad debts called provisioning for bad loans/ or loan loss provisions. It is similar to bad debt expense in non financial cos.
Capital losses on Securities, computing, etc

5. Non Interest Revenues:
Lockers fee
L/C fees
L/G fees . Letters of guarantee issued by a bank on behalf of a client
Account Maintenance fee
DD/ TT fee
ATM fees
Credit Card fee
Trust Service fee
Commitment fee
Bank guarantee fee
Traveler’s checks making and cashing fees
Underwriting fees for underwriting security issue of a client

6. NIE (Net Non Interest Expense) = Non interest expenses – Non interest income
NIM = Spread /TA= (IR – IE)/TA= { (r*TA) - (c*TL) }/ TA = r- (c* TL/TA)

7. EXERCISE: BALANCE SHEET Of FI (Millions of Rs) ASSETS Y* LIAB Y*
Cash % Demand Deposits %
Short term Securities % S. Term Saving Deposits %
Long term Invest % L. T Saving Deposits %
S.T. Loans % TFCs issued %
Medium Term Loans % TL
Long Term Loans % Share Capital 3
Premesis (i.e. FA) % RE
TA Total OE (NW) 7
TL & OE
Non interest revenues are forecasted as 10, and non interest expense as 5 for the next year. The co has “d” of 40%, Tax rate is 30%, and it has 5 shares.

8. Required: r c
EPS
DPS
RE increase in next yr.
RE balance at the end of next yr.
OE at the end of yr.
Financial Leverage = TA / NW (Beginning Of Period)
Capital Adequacy ratio = NW/ TA
Does it have Adequate Capital ? Int’l standard for the capital adequacy ratio is 4%
RONW = NI / NW
ROA = NI / TA
Double check RONW = TA / NW *ROA (i.e financial leverage * Return on assets)
NIM = Spread /TA
NIM = (IR-IE) /TA
NIM = {(r*TA) ( c*TL) } / TA
NIM = r- {c*TL/TA }
Please Complete the forecasted Income Statement

9. Sequence of Steps in ALM (Asset / Liability Management)
ALM refers to simultaneous management of assets and liabilities of any financial institution to achieve its target RONW ( ROE) .
HOW IS IT DONE?
1. Managing the size of NIM
2. managing the risk of NIM
Step1. Managing the size of NIM
Set a RONW target for next year ( because co’s owners are most important, and the return on their investment is NI / OE)
Given the regulation about Capital Adequacy and Tax rate, set NIM target for The next year to achieve the target RONW.
Given the NIM target , set the targets for r (effective annual yield on assets) & c (effective annual yield on liabilities)
Given the targets r on assets, decide the amounts and yields (‘r’s) of different types of assets you want to have in your balance sheet . Similarly given the target ‘c’ on liabilities, decide the amounts and yield (‘c’s) of different types of liabilities you want to have in your balance sheet .

10. Step 2. Managing the risk of NIM 1. By Restructuring the Balance Sheet
a) Rate sensitive GAP management
b) Duration GAP Mgmt.
Please note the restructuring needed to manage rate sensitive GAP may not be suitable to manage Duration GAP. So there is possibility that the management strategy for rate sensitive gap ( also called funding GAP, Maturities mismatching GAP) may go counter to the strategy for Duration GAP management; and manager may face a dilemma as to which GAP to manage and which GAP to leave un managed.

11. 2. Without restructuring the Balance Sheet: by using financial derivative such as :
i-rate Futures contracts
i-rate Options contracts
i- rate Swap contracts
i-rate swap options
i-rate Caps, floors
you can achieve the same desired future CFs (cash flows) pattern by taking position in the above stated derivative contracts as you would achieve by restructuring the balance sheet.

12. Exercise:
A financial Institution has target for RONW=30%. It earns 15% yield (r )on its assets, its tax rate is 60% . Govt.’s capital adequacy requirement is minimum 10% , its NIE / TA ratio is 2% and its TL / TA ratio = 90%.
Required:
What should be its cost of funds to achieve target RONW? (i.e. c)
What should be is NIM to achieve target RONW?
If Govt. changes the Capital Adequacy rules and brings it at par with the int’l standards (4%), then what RONW it can expect to earn, keeping the target NIM same as in no. 2 above.

13. Solution
1).NIM= {RONW * NW/TA * 1/(1-t)} + NIE/TA = r - (c * TL/TA) {0.3*0.10*1/(1-0.6)} = (c* 0.9) 0.095= c = -0.90c = -0.90c =c (i.e. 6.11%) 2. NIM= { RONW * NW/TA* 1/(1-t)} + NIE/TA = {0.3 * 0.1 * 1 / (1-0.6)} = i.e. 9.5% 3. NIM= { RONW * NW/TA * 1/(1-t)} + NIE/TA 0.095= { RONW * 0.04 * 1/(1-0.6)} = (RONW* 0.1) = ( RONW * 0.01) 0.075/0.01= RONW 0.75 =RONW i.e 75%

14. RESULT:
When Capital Adequacy  from 10% to 4%:
RONW  from30% to 75%
Financial Leverage (TA / NW) is  from 1/10% =10 time to 1/ 4%= 25 time
When FI  Financial leverage its RONW 
In good economic times , when revenue  , high Fin leverage   RONW
In bad economies when revenue  , high Financial Leverage causes  in RONW
How to  Financial Leverage ?
 (TA/NW) i.e NW Multiplier ratio
(TL/ TA) i.e Debt Ratio
(TL / NW) i.e Debt Equity Ratio
to  TA /NW , you can  NW by : issuing shares to raise fresh equity, or increasing NI and therefore RE, or by only decreasing dividends and thus increasing RE without increasing NI. A FIs’ financial leverage should be adjusted according to the economic conditions in the country, and should be such that it does not violate minimum capital adequacy requirements.
In Recession: it is sensible to have  Leverage and in Boom  Leverage; but ability to correctly predict recession or boom for the next year is self questionable; please note that not many economist were correct in 2007 in predicting the ensuing recession of
However, apart from economic conditions other variables have to be considered as well.
A bank can TL by decreasing the deposits  by  i-rates on deposits and thus discouraging depositors, or by  minimum balance requirement of depositors , again to discourage depositors.

15. EXERCISE
A FI institution has c of 7% and r of 11%. It is operating at minimum capital adequacy of 4%. Tax rate is 50%. Its NIE / TA ratio is 3%.
REQUIRED:
TL/TA ratio
NIM it can earn
RONW it can earn
If this bank has a target of 25% for its RONW then what NIM should it earn?
To achieve 5% NIM, what yield on assets this bank should earn?
What was the required %age change in NIM to achieve target RONW of 25%
Increasing NIM 16.82% caused what %age change in RONW
To achieve 16.82% increase in NIM, you needed to make what %age change in yield on assets ( r )?

16. Solution
1) NW /TA is given 4%. TA = TL + NW. TA / TA = TL / TA + NW /TA 1 = TL /TA TL /TA = ) NIM = r - c * TL/TA. = 11% - 7%*0.96. =11% %. = 4.28% 3) NIM = [ RONW * NW / TA * 1 / ( 1 – T)] + NIE /TA 4.28% = [RONW * 4% * 1 / (1 -0.5)] + 3%. 4.28% = [RONW * 4% * 2] + 3% 4.28% = [RONW *8%] + 3% 4.28% - 3% = RONW * 8% 1.28% / 8% = RONW 0.16 = RONW = 16%

17. Solution 4) NIM = [RONW * NW / TA * 1 / (1 – T)] + NIE / TA
= [0.25 * 0.04 * 1 / (1 –0.5)]
= [ 0.02]
= 0.05 = 5%
5) NIM = r – c* TL / TA
0.05 = r * 0.96
0.05 = r
= r
= r = %
6) (0.05 – ) / = %
7) ( 25% - 16%) / 16% = 56.25%
8)(11.72% - 11%) / 11% = 6.54%
NOTE: A 6.54% increase in r caused 16.82% increase in NIM, and 16.82% increase in NIM caused 56.25% increase in RONW. This is a prove that FIs are highly leveraged businesses, and minor improvements on revenue earning side have magnified impact on return for owners; the same is true for cost cutting, a slight decrease in cost of funds would have magnified impact on RONW.