DEPARTMENT OF COMMERCE (PG)

Subject Code: 2.6 Subject Name: Asset Liability Management in Banks

AIGS Class: II Sem MFA
CHAPTER 1: Introduction

Definitions:
Repo (Repurchase) rate is the rate at which banks borrow funds from the RBI to meet the gap
between the demand they are facing for money (loans) and how much they have on hand to
lend.

Reverse repo rate is the rate at which RBI borrows money from the banks (or banks lend
money to the RBI).

Reverse repo rate signifies the rate at which the central bank absorbs liquidity from the banks,
while repo signifies the rate at which liquidity is injected.

Bank Rate is the rate at which RBI lends money to other banks (or financial institutions).
This is the rate at which RBI rediscounts bills.

Call rate is the interest rate paid by the banks for lending and borrowing for daily fund
requirements.

Cash Reserve Ratio (CRR) refers to a portion of deposits (as cash) which banks have to
keep/maintain with the RBI.

Statutory Liquidity Ratio (SLR) refers to the amount of liquid assets, such as cash, precious
metals or other short-term securities, that a financial institution must maintain in its reserves.

Money Market is the market for short-term financial instruments. Money market instruments
include Treasury bills, bankers acceptances, commercial paper, Federal funds, municipal
notes, and other securities. The common characteristic of money market instruments is that
they all have maturities of one year or less, and often 30 days or less.

Capital market is a market for financial assets which have a long or indefinite maturity.

MSF- rate at which banks can borrow overnight funds from RBI, especially during acute
shortage of cash - Marginal Standing Facility.

Net Interest Margin is the difference between the interest income generated by banks or other
financial institutions and the amount of interest paid out to their lenders (for example,
deposits), relative to the amount of their (interest-earning) assets, usually expressed in terms
of percentage.

Net Interest Income is the difference between revenues generated by interest-bearing assets
and the cost of servicing (interest-burdened) liabilities.

SDR: The SDR is an international reserve asset, created by the IMF in 1969 to supplement
the existing official reserves of member countries

PLR: Prime lending rate is the rate that the bank will lend to its best customers. Floating rate
loans will be quoted as something like PLR+_ 1%, when RBI changes SLR, CRR etc banks
will announce chnage in PLR and other loans interest will be changed accordingly
 DEPARTMENT OF COMMERCE (PG)
Subject Code: 2.6 Subject Name: Asset Liability Management in Banks
AIGS Class: II Sem MFA
CAR: Capital Adequacy ratio is the amount of capital that shareholders should put in for each
100 deposits with bank. For ex if CAR is 12.5% and a bank has a deposit base of 100, then
Bank's share capital + reserves and surplus should be at least 12.5.

Bank rate is the interest rate at which a nation's central bank lends money to domestic banks.

About ALM
Asset/Liability Management (ALM) is a technique companies employ in coordinating the
management of assets and liabilities so that an adequate return may be earned.

Asset Liability Management (ALM) can be defined as a mechanism to address the risk faced
by a bank due to a mismatch between assets and liabilities either due to liquidity or changes
in interest rates.

Liquidity is an institution’s ability to meet its liabilities either by borrowing or converting

assets. Apart from liquidity, a bank may also have a mismatch due to changes in interest rates
as banks typically tend to borrow short term (fixed or floating) and lend long term (fixed or
floating). A comprehensive ALM policy framework focuses on bank profitability and long-
term viability by targeting the net interest margin (NIM) ratio and Net Economic Value (NEV
- the difference between the fair value of the banks' assets, and the fair value of its liabilities),
subject to balance sheet constraints. Significant among these constraints are maintaining
credit quality, meeting liquidity needs and obtaining sufficient capital. An insightful view of
ALM is that it simply combines portfolio management techniques (that is, asset, liability and
spread management) into a coordinated process. Thus, the central theme of ALM is the
coordinated – and not piecemeal – management of a bank’s entire balance sheet.

At the very foundation of ALM is the notion that there exists some set of liabilities that need
to be funded by assets. The structure of the asset portfolio is therefore driven by the structure
of the liabilities. Both assets and liabilities are exposed to forces that influence their
individual performances, but it is the collective performance of the portfolio of assets to
cover the liabilities that is the primary management objective.

The following are the objectives of ALM:

1. Managing Net Interest Margin [difference between the interest income generated by
banks or other financial institutions and the amount of interest paid out to their lenders
(for example, deposits), relative to the amount of their (interest-earning) assets,
usually expressed in percentage]

to produce consistent growth in the loan portfolio and shareholder earnings, regardless
of short-term movement in interest rates. The currency difference between assets
(loans) maturing or re-pricing and liabilities (deposits) is known as the Rate
Sensitivity Gap (or Maturity Gap). Banks attempt to manage this asset-liability gap by
pricing some of their loans at variable interest rates.
2. Liquidity Risk Management
3. Interest Rate Risk Management
4. Currency Risks Management
 DEPARTMENT OF COMMERCE (PG)
Subject Code: 2.6 Subject Name: Asset Liability Management in Banks
AIGS Class: II Sem MFA
5. Profit Planning and Growth Projection

The following are the functions of ALM:

1. To measure and control three levels of financial risk: Interest Rate Risk (the pricing
difference between loans and deposits), Credit Risk (the probability of default), and
Liquidity Risk (occurring when loans and deposits have different maturities).
2. Manage the firm’s capital resources with an eye to achieving the lowest cost of
capital.

Liquidity is affected by ALM decisions in several ways:

1. Any changes in the maturity structure of the assets and liabilities can change the cash
requirements and flows.
2. Savings or credit promotions to better serve clients or change the ALM mix could
have a detrimental effect on liquidity, if not monitored closely.
3. Changes in interest rates could impact liquidity. If savings rates are lowered, clients
might withdraw their funds and cause a liquidity shortfall. Higher interest rates on
loans could make it difficult for some clients to meet interest payments, causing a
liquidity shortage.

As in all operational areas, ALM must be guided by a formal policy that was developed and
written by the officials with the assistance of operational management. The policy should be
reviewed by officials annually and revised as needed. The ALM and liquidity policies may be
two separate policies or one comprehensive policy. In any case, the ALM and liquidity
policies cannot be written in isolation, as decisions on lending, investments, liabilities, and
equity are all interrelated. The ALM policy should discuss:
1. Who is responsible for monitoring the ALM position of the institution.
2. What tools will be used to monitor ALM. How often the ALM position will be
analyzed and discussed with officials and management.
3. What are the acceptable parameters or ranges for ALM ratios or indicators.

The pillars of ALM are as follows:

 ALM information systems
 Management Information System
 Information availability, accuracy, adequacy and expediency
 ALM organisation
 Structure and responsibilities
 Level of top management involvement
 ALM process
 Risk parameters
 Risk identification
 Risk measurement
 Risk management
 Risk policies and tolerance levels

Emerging Trends in Banking

Indian banking system will further grow in size and complexity while acting as an important
agent of economic growth and intermingling different segments of the financial sector. It
automatically follows that the future of Indian banking depends not only in internal dynamics
unleashed by ongoing returns but also on global trends in the financial sectors. Indian
 DEPARTMENT OF COMMERCE (PG)
Subject Code: 2.6 Subject Name: Asset Liability Management in Banks
AIGS Class: II Sem MFA
Banking Industry has shown considerable resilience during the return period. The second
generation returns will play a crucial role in further strengthening the system. Adoption of
stringent prudential norms and higher capital standards, better risk management systems,
adoption of internationally accepted accounting practices and increased disclosures and
transparency will ensure the Indian Banking industry keeps pace with other developed
banking systems.

The following are the emerging issues in banking:

1. Adoption of technology - ATM, Internet banking, mobile banking, RTGS, etc...
2. Financial innovations - newer financial products, financial engineering, derivatives,
etc...
3. Manpower issues - training and re-deployment, retirement, etc...
4. CRM - Data mining, help desks, call centres, ESS, etc ...
5. Retail banking
6. Credit to weaker sections
7. Financial inclusion
8. MSME funding

Significance
ALM is important due to the following reasons:
1. Globalisation of financial markets
2. Deregulation of Interest Rates
3. Multi-currency Balance Sheet
4. Prevalence of Basis Risk and Embedded Option Risk
5. Integration of Markets – Money Market, Forex Market, Government Securities
Market
6. Narrowing Net Interest Income (NII) and Net Income Margin (NIM)
7. Volatility
8. Product Innovation
9. Regulatory Framework
10. Management Recognition

The following are the advantages:

 ALM can help protect a financial institution or corporation against a variety of
financial and nonfinancial risks.
 The mere process of identifying risks enables businesses to be better prepared to deal
with these risks in the most cost-effective way.
 ALM ensures that a company’s capital and assets are used in the most efficient way.
 It can be used as a strategic and business tool to improve earnings.

The following are the disadvantages:

 ALM is only as good as the people on the ALM committee and the operational
procedures that they follow.
 ALM can prove costly in terms of both the time required of employees and the
investment required in management tools such as IT and techniques such as hedging.

In addition, management must have established the following to strengthen ALM:

1. Short and long-term minimum capital or equity/total assets goal ratios.
 DEPARTMENT OF COMMERCE (PG)
Subject Code: 2.6 Subject Name: Asset Liability Management in Banks
AIGS Class: II Sem MFA
2. The maximum percentage of assets to be held by any one client, in different types of
loans and investments, in fixed rate investments and loans with a maturity greater than
one year, and invested in fixed assets.
3. The desired diversification of savings and deposits to eliminate potential
concentration risk (having too much in any one type of deposit or with any one
client).
4. Maximum maturities for all types of loans, investments, and deposits.
5. Establishment of fixed or variable interest rate loans and deposits.
6. Pricing strategies for loans and savings products that are based on what it actually
costs to offer the products and what the local market will bear.

ALCO
The Asset-Liability Committee (ALCO) is a risk-management committee in a bank or other
lending institution that generally comprises the senior-management levels of the institution.
The ALCO is a decision making unit responsible for balance sheet planning from risk-return
perspective including the strategic management of interest rate and liquidity risks. Each bank
will have to decide on the role of its ALCO, its responsibility as also the decisions to be taken
by it.

The following is the composition of ALCO:

The size (number of members) of ALCO would depend on the size of each institution,
business mix and organisational complexity. To ensure commitment of top management, the
CEO/CMD or ED should head the Committee. The Chiefs of Investment, Credit, Funds
Management/Treasury (forex and domestic), International Banking and Economic Research
can be members of the Committee. In addition the Head of the Information Technology
Division should also be an invitee for building up of MIS and related computerisation. Some
banks may even have sub-committees.

ALM Guidelines
The RBI guidelines are as follows:
 Structural liquidity statement
 Dynamic liquidity statement
 Board/ALCO
o ALM Information System
o ALM organisation
o ALM process (Risk Management process)
 Mismatch limits in the gap statement
 Assumptions/Behavioural study

The Structural Liquidity Statement consists of the following:

 Placed all cash inflows and outflows in the maturity ladder as per residual maturity
 Maturing Liability : Cash Outflow (Customer deposits)
 Maturing Assets : Cash Inflow (Customer loans)
 Maturity profile of SSL classified into 8 time buckets:
i. 1-14 days
ii. 15-28 days
iii. 29 and up to 3 months
iv. Over 3months and up to 6 months
v. Over 6 months and up to 1 year
 DEPARTMENT OF COMMERCE (PG)
Subject Code: 2.6 Subject Name: Asset Liability Management in Banks
AIGS Class: II Sem MFA
vi. Over 1 year and up to 3 years
vii. Over 3 years and up to 5 years
viii. Over 5 years
 Mismatches in the first two buckets not to exceed 20% of outflows
 Banks can fix higher tolerance level for other maturity buckets

The Dynamic Liquidity Statement comprises of the following:

 Short Term Dynamic Liquidity Statement prepared for the following durations:
a. 1-14 days
b. 15-28 days
c. 29-90 days
 Outflows
 Inflows
 Mismatch
 Cumulative mismatch

Mismatch is the difference between the maturing assets and maturing liabilities.
Mismatch = Maturing Assets – Maturing Liabilities

Positive Mismatch => Maturing Assets > Maturing Liabilities

Negative Mismatch => Maturing Liabilities > Maturing Assets

In case of positive mismatch, excess liquidity can be deployed in money market instruments,
creating new assets & investment swaps etc... For negative mismatch, it can be financed
from market borrowings(call/Term), Bills rediscounting, repos & deployment of foreign
currency converted into Rupee.

ALM Information System

Information is the key to the ALM process. Considering the large network of branches and
the lack of an adequate system to collect information required for ALM which analyses
information on the basis of residual maturity and behavioural pattern it will take time for
banks in the present state to get the requisite information. The problem of ALM needs to be
addressed by following an ABC approach i.e. analysing the behaviour of asset and liability
products in the top branches accounting for significant business and then making rational
assumptions about the way in which assets and liabilities would behave in other branches. In
respect of foreign exchange, investment portfolio and money market operations, in view of
the centralised nature of the functions, it would be much easier to collect reliable information.
The data and assumptions can then be refined over time as the bank management gain
experience of conducting business within an ALM framework. The spread of
computerisation will also help banks in accessing data.

ALM Organization
a) The Board should have overall responsibility for management of risks and should
decide the risk management policy of the bank and set limits for liquidity, interest
rate, foreign exchange and equity price risks.
b) The Asset - Liability Committee (ALCO) consisting of the bank's senior management
including CEO should be responsible for ensuring adherence to the limits set by the
Board as well as for deciding the business strategy of the bank (on the assets and
 DEPARTMENT OF COMMERCE (PG)
Subject Code: 2.6 Subject Name: Asset Liability Management in Banks
AIGS Class: II Sem MFA
liabilities sides) in line with the bank's budget and decided risk management
objectives.
c) The ALM desk consisting of operating staff should be responsible for analysing,
monitoring and reporting the risk profiles to the ALCO. The staff should also prepare
forecasts (simulations) showing the effects of various possible changes in market
conditions related to the balance sheet and recommend the action needed to adhere to
bank's internal limits.

The ALCO is a decision making unit responsible for balance sheet planning from risk - return
perspective including the strategic management of interest rate and liquidity risks. Each bank
will have to decide on the role of its ALCO, its responsibility as also the decisions to be taken
by it. The business and risk management strategy of the bank should ensure that the bank
operates within the limits / parameters set by the Board. The business issues that an ALCO
would consider, inter alia, will include product pricing for both deposits and advances,
desired maturity profile of the incremental assets and liabilities, etc. In addition to monitoring
the risk levels of the bank, the ALCO should review the results of and progress in
implementation of the decisions made in the previous meetings. The ALCO would also
articulate the current interest rate view of the bank and base its decisions for future business
strategy on this view. In respect of the funding policy, for instance, its responsibility would
be to decide on source and mix of liabilities or sale of assets. Towards this end, 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, etc... Individual banks will have to
decide the frequency for holding their ALCO meetings.

ALM Process
The scope of ALM function can be described as follows:
 Liquidity risk management
 Management of market risks (including Interest Rate Risk)
 Funding and capital planning
 Profit planning and growth projection
 Trading risk management

The guidelines given in this note mainly address Liquidity and Interest Rate risks.

Mismatch limits in GAP statement

Gap reports are commonly used to assess and manage interest rate risk exposure-specifically,
a banks re-pricing and maturity imbalances. However, a basic gap report can be unreliable
indicator of a bank’s overall interest rate risk exposure.

Assumptions/Behavioural Study
In the Interest Rate Sensitivity (IRS) Statement as per format prescribed in Appendix II,
while RSA and RSL with fixed maturities are straightaway classified in the relevant time
buckets based on residual maturity/ re-pricing dates, there could be an element of variance in
the manner of bucketing those items which do not have a fixed maturity or have embedded
optionality (i.e. savings bank deposits, current account deposits and mortgage loans etc.).
This calls for behavioural studies to be undertaken by banks in order to have a realistic
assessment of the interest rate sensitivity, an issue which has already been highlighted in the
present ALM guidelines. Banks should not only have an appropriate process to conduct such
 DEPARTMENT OF COMMERCE (PG)
Subject Code: 2.6 Subject Name: Asset Liability Management in Banks
AIGS Class: II Sem MFA
behavioural studies in a consistent manner, but also have a detailed framework to review
these studies and their output periodically (say annually). Banks may apply the results of the
behavioural studies on a consistent basis and the results may be reviewed/revised once a year
in the first quarter of the financial year, if necessary. The behavioural studies should be based
on at least three years data. Banks may evolve a suitable mechanism, supported by empirical
studies and behavioural analysis to estimate the future behaviour of assets and liabilities and
off-balance sheet items with respect to changes in market variables.

ALM in Indian Banks

Over the last few years the Indian financial markets have witnessed wide ranging changes at
fast pace. Intense competition for business involving both the assets and liabilities, together
with increasing volatility in the domestic interest rates as well as foreign exchange rates, has
brought pressure on the management of banks to maintain a good balance among spreads,
profitability and long-term viability. These pressures call for structured and comprehensive
measures and not just ad-hoc action. The Management of banks has to base their business
decisions on a dynamic and integrated risk management system and process, driven by
corporate strategy. Banks are exposed to several major risks in the course of their business -
credit risk, interest rate risk, foreign exchange risk, equity / commodity price risk, liquidity
risk and operational risks.

ALM has been there since the days of banking in India. However, banks adopted ALM in
1999.

Reclassification of Assets and Liabilities

 DEPARTMENT OF COMMERCE (PG)
Subject Code: 2.6 Subject Name: Asset Liability Management in Banks
AIGS Class: II Sem MFA

Liquidity-return profile of assets

Maturity-cost profile of liabilities

The different risks are:

 Interest risk
 Foreign exchange risk
 Liquidity risk
 Credit risk
 Contingency risk

Implementing Asset Liability Management (ALM) function in banks is not only a regulatory
requirement in India but also an imperative for strategic bank management. For any risk
measurement in finance, all complex instruments are reduced to simple instrument in an
artificial manner, preserving market value and market risk. Then, simple instruments are
analysed for risks.

1. GAP Analysis Model

2. Duration GAP Analysis Model
3. Scenario Analysis Model
 DEPARTMENT OF COMMERCE (PG)
Subject Code: 2.6 Subject Name: Asset Liability Management in Banks
AIGS Class: II Sem MFA
4. Value at Risk (VaR) model
5. Stochastic Programming Model

GAP Analysis Model

Gap analysis is a technique of asset-liability management that can be used to assess interest
rate risk or liquidity risk. It measures at a given date the gaps between rate sensitive liabilities
(RSL) and rate sensitive assets (RSA) (including off-balance sheet positions) by grouping
them into time buckets according to residual maturity or next repricing period, whichever is
earlier. An asset or liability is treated as rate sensitive if
i) within the time bucket under consideration, there is a cash flow;
ii) the interest rate resets/reprices contractually during the time buckets;
iii) administered rates are changed and iv) it is contractually prepayable or withdrawal
allowed before contracted maturities. Thus,
Gap = RSA – RSL;
Gap Ratio = RSAs/RSLs.

This gap is used as a measure of interest rate sensitivity. The positive or negative gap is
multiplied by the assumed interest changes to derive the Earnings at Risk (EaR). A bank
benefits from a positive Gap (RSA>RSL), if interest rate rises. Similarly, a negative Gap
(RSA<RSL) is advantageous during the period of falling interest rate. The interest rate risk is
minimized if the gap is near zero.

Gap analysis was widely adopted by financial institutions during the 1980s. When used to
manage interest rate risk, it was used in tandem with duration analysis. Both techniques have
their own strengths and weaknesses. Duration analysis summarizes, with a single number,
exposure to parallel shifts in the term structure of interest rates. Though gap analysis is more
cumbersome and less widely applicable, it addresses exposure to other term structure
movements, such as tilts or bends. It also assesses exposure to a greater variety of term
structure movements.

Duration Analysis
Otherwise called Duration Gap Analysis:
 Duration is a measure of percentage change in the economic value of a position that
will occur given a small change in the level of interest rates.
 It focuses on market value of equity.
 Difference between duration of assets and liabilities is bank’s net duration.
 If DA>DL, a decrease in interest rate will increase the Market Value of Equity of the
bank.
 If DL>DA, an increase in interest rate will increase the MVE of the bank and a
decrease in interest rate will decrease the MVE of the bank.
 Duration Gap Analysis recognises the time value of money.

Market Value of Equity = Market Value of Asset – Market Value of Liability.

Duration gap analysis recognizes the time value of money. Time Value of Money refers to
the idea that a particular currency now is worth more than it in the future, even after adjusting
for inflation.
 DEPARTMENT OF COMMERCE (PG)
Subject Code: 2.6 Subject Name: Asset Liability Management in Banks
AIGS Class: II Sem MFA

3_3-Duration
Analysis.pdf

VaR (Value at Risk) Model

VaR is the maximum potential loss in market value or income
 over a given time horizon,
 under normal market conditions,
 at a given level of certainty.

VaR serves as Information Reporting to stakeholders.

 Performance Evaluation i.e. returns generated of individuals/business units for the
risks taken and subsequently allow for comparison.
 Resource Allocation (capital and personnel) to provide a higher risk adjusted
profitability.
 Regulatory (to impart stability to the overall financial system)

VaR is measured by Standard Deviation of unexpected outcome (volatility) - σ (“sigma”)

Normal distribution is characterised by two parameters:
i) Its mean μ (“mu”) and ii) Standard Deviation σ (“sigma”)

Basel Norms.docx

caiib-riskmgt-a.ppt

Volatality = Standard deviation / Mean

 DEPARTMENT OF COMMERCE (PG)
Subject Code: 2.6 Subject Name: Asset Liability Management in Banks
AIGS Class: II Sem MFA