ASSET LIABILITY MANAGEMENT:

LIQUIDITY RISK AND INTEREST RATE RISK

THE 2023 US BANKING CRISIS @ SVB

THIS DOCUMENT IS NOT FOR CIRCULATION

INTRODUCTION

In 2023, one of the most significant events in banking and capital markets has been
the collapse of Silicon Valley Bank(SVB), a mid-sized bank in the US. The main reason
for the bank’s failure was Asset Liability mis management. This document also
illustrates key concepts in Debt Markets, from a banking perspective.

What are the factors that distinguish a “strong” bank from a “weak/failing” bank?

1)Asset quality: Is the bank lending to corporate borrowers with good credit rating
and individuals with excellent credit score? Is the bank’s portfolio skewed towards
unsecured personal loans or secured housing loans? What is the extent of stressed
loans and NPAs(non-performing assets)?

2)Capital Adequacy: what is the capital adequacy ratio of the bank? Capital has the
key role of absorbing losses, which will be explained in a subsequent document.

3)Profitability: Measured through Return on Assets, Return on tangible equity and

Net Interest Margin.

4)Efficiency: Measured through cost income ratio, credit deposit ratio.

The above concepts are explained in the article “Banking on Performance” by

Balachandran R, published on the IIM Calcutta website(reading is optional):
https://www.iimcal.ac.in/sites/all/files/pdfs/volume4_issue6_july_2018.pdf

5) Management quality

6)Other measures like

• Growth
• CASA(current and savings account) to total deposits ratio
• Diversified loan portfolio
• Diversified funding mix

A bank may have good asset quality, be well capitalised and profitable, but can still
fail:
• If it does not have sufficient liquidity to meet its maturing obligations
✓ Maturing obligations are deposits taken by a bank and other
borrowings.
Risk of not being able to meet maturing obligations (without incurring unsustainable
losses) is called LIQUIDITY RISK.

The Asset Liability Management (ALM) function of a bank addresses:

• Liquidity risk: explained in the first section of this document.

• Interest rate risk: explained in the second section of this document.

WHY DOES LIQUIDITY RISK ARISE?

Let us look at the balance sheet of a blue chip bank in India, HDFC Bank, considered
one of the best banks not only in India, but in Asia. HDFC bank’s market capitalisation
of about USD 130 billion, is higher than that of the American banking giant Citigroup
and the German behemoth Deutsche Bank.

• Deposits of HDFC Bank: Rs 19 lakh cr

• Cash/balance with RBI/investments/others: Rs 7 lakh cr
(Assume that all investments are liquid)

If all the depositors ask for their money back at the same time, and assuming that
there is a ready market for all the bank’s investments and the bank is able to sell
them without losses:
• The bank will be able to raise Rs 7 lakh cr by selling investments
• Against a requirement to meet deposit outflow of Rs 19 lakh cr.

Hence, whether it is HDFC Bank or the blue chip American bank JP Morgan Chase, no
bank will be able to repay its depositors, if all of them try to withdraw their deposits
at the same time.

• Therefore, banking is based on trust, confidence and faith of depositors.

If depositors lose their confidence in a bank, it may result in a panic run on the bank
and its eventual failure.
• That happened to Silicon Valley Bank(SVB) in March 2023.

THE 2023 ALM(ASSET LIABILITY MANAGEMENT) CRISIS AT SILICON VALLEY BANK

SVB has traditionally been the “go to” bank for

• VC (Venture capital )firms in the Silicon Valley (San Francisco Bay Area)
• The VC firms’ portfolio companies: the startups and tech companies that the
VC firms invest in
In 2020, to counter the impact of the Covid pandemic on the economy, the Federal
Reserve of the US, reduced interest rates to zero and pumped in liquidity of about
USD 5 trillion into the economy.

• Market interest rates crashed, bank deposits fetched a negligible interest rate,
and rates on corporate bonds too fell sharply.

Hungry for yield, money from investors poured into venture capital firms, who in turn
flooded their portfolio companies (startups and other tech companies) with cash. SVB
was a major beneficiary of the Fed(Federal Reserve) induced cash into the economy,
with deposits nearly doubling from about USD 100 billion to USD 190 billion in a
short period.

SVB chose to invest the flood of money into long duration US government securities,
considered the safest security in the world.

The tide turns

All the cash induced into the economy by the UD Federal Reserve(Fed), coupled with
the war in Ukraine, led to a massive spike in inflation in 2022. To counter this, the Fed
started increasing interest rates, and over a period of 1 year, it raised the rates by 5%.
Market rates followed suit; US 10 year government securities yield in the market,
rose from a low of 0.5% in 2020, to more than 4% in 2022.

When market interest rates rise, prices of bonds fall.

https://www.sec.gov/files/ib_interestraterisk.pdf

SVB made significant losses on its investments in long duration US government

securities, when interest rates went up.
✓ Long duration bonds are much more sensitive to changes in markets interest
rates than short duration bonds.

In addition, SVB in 2022/early 2023, lost deposits as its customers(startups) facing a

market downturn for technology companies and high cash burn, started withdrawing
some of their funds impacting SVB’s liquidity adversely.

• SVB, with the help of Goldman Sachs, sold some of its bond portfolio at a loss
(USD 1.8 billion by one estimate), to meet the redemption requests from
depositors.
 • Moody’s, the credit rating agency, downgraded SVB’s rating.
• The bank’s stock price crashed by 60% on one day-March 9, 2023.

Fearing possible insolvency/failure of Silicon Valley Bank, VC(venture capital) firms

advised the start-ups that they had invested in, to withdraw all their funds from SVB.
The VCs too withdrew their deposits from SVB.
• SVB’s depositors pulled about USD 42 billion of deposits in one day, over just a
few hours. This was about 25% of its deposit base.
• Most of the rest of the deposits was poised to leave the next day.

Digital bank run

There have been many bank runs in the past, including the run on Lehman Brothers
in 2008.
But SVB was possibly the first “I Phone” and social media led bank run.

• I phones/smartphones have made moving money much faster compared to

previous bank runs. Past bank runs witnessed depositors queuing up in front
of physical bank branches demanding their money bank.
✓ Today digital bank runs can happen in seconds, thanks to electronic
funds transfer facility through mobile apps enabling instant movement
of funds by customers, from a “failing bank” to a “safe bank”.
• Social media triggers- as Citigroup CEO Jane Fraser said:
✓ “There were a couple of Tweets and then this thing(SVB) went down
much faster than has happened in history”
• Of course, WhatsApp too played a role in the rapid unravelling of SVB !
o One prominent technology CEO told CNBC that numerous startup
founders were using Twitter and WhatsApp to send each other rapid-
fire updates.

To quote legendary investor Warren Buffet, banks can lose the confidence of the
public in seconds.

Precisely to counter these situations, and prevent bank runs, regulators insure bank
deposits so that investors need not panic:
• FDIC insures USD 250,000 of bank deposits in the US
• DICGC ( subsidiary of RBI) insures Rs 5 lakhs of bank deposits in India.

Unfortunately, SVB depended on wholesale/bulk(large value) deposits, of much more

than USD 250,000: 88% of the bank’s deposits were uninsured.
With SVB coming to the brink of collapse on March 9, 2023, in the wake of a panic
run and en masse withdrawal of deposits, the FDIC (US bank regulator), stepped in on
the same day, and seized SVB.

It assured that all depositors of SVB would be repaid, despite insurance being
limited to USD 250,000.
It subsequently arranged for SVB to be taken over by First Citizens Bank.

Why did the FDIC repay uninsured deposits?

To prevent contagion.
• If one bank fails, investors may start having worries about other banks of
similar size/profile, leading to more bank runs, threatening the stability of the
entire financial system.

Despite the FDIC rescuing SVB, the fear of depositors spread to other mid-sized
lenders, with First Republic Bank next facing a panic run. The US authorities stepped
in, and arranged a merger of First Republic Bank with JP Morgan Chase Bank, the
largest American Bank.

Half of America’s banks insolvent!

https://finance.yahoo.com/news/half-america-banks-already-insolvent-
133000968.html

Impact across the Atlantic in Europe

The impact of the banking crisis in the US was felt around the world. Credit Suisse,
already mired in losses and scandals, faced a similar crisis and mass withdrawals.
Over a weekend in March 2023, soon after the SVB crisis, the Swiss regulator,
arranged for the merger of Credit Suisse with the largest bank in Switzerland, UBS, to
avoid contagion to the financial system,
• In a controversial move, AT1 bond holders of Swiss Francs 16 billion saw their
entire investment wiped out, while depositors were fully protected. AT1 bonds
will be discussed subsequently.

Bank runs in India

RBI in 2020, facilitated the rescue of Yes Bank with significant capital infusions from
India’s largest Bank, SBI, and other banks, to prevent contagion risk.
There was a run on ICICI Bank in 2008, following its rumoured exposure to Lehman
Brothers. RBI threw its weight behind ICICI Bank and issued the following statement
to back the bank:

"ICICI Bank has sufficient liquidity, including in its current account with the RBI, to
meet the requirements of its depositors. The RBI is monitoring the developments and
has arranged to provide adequate cash to ICICI Bank to meet the demands of its
customers at its branches and ATMs. The ICICI Bank and its subsidiary banks abroad
are well capitalised."

The panic run subsided and today ICICI Bank is one of India’s most important banks
with a market capitalisation of about Rs 6.5 lakh crores.

Silicon Valley Bank (SVB) collapse in summary

SVB mismanaged both the assets and liabilities side of its balance sheet:

LIABILITIES

During the early phase of the Covid pandemic, with the tech sector booming, SVB
saw significant deposit growth. These liabilities were largely composed of deposits
from venture capital firms and the tech sector, which were highly concentrated and
potentially unstable.

From an ALM perspective,

• A diversified deposit portfolio from a large base of retail investors is much
more prudent than relying on unstable wholesale/bulk deposits from a smaller
base of high value depositors.
• Retail deposits are sticky and tend to be rolled over/renewed on maturity.
✓ A bank with a deposit base of concentrated wholesale deposits is much
more vulnerable to panic runs.

Large banks like JP Morgan Chase Bank and SBI are likely to have well-diversified
funding sources unlike SVB whose customers were mainly venture-capital firms and
their portfolio companies going through a tough macro environment.

ASSETS

SVB invested the proceeds of the bulk deposits from the VC world in long duration US
government securities, to boost yield and increase its profits. However, the bank did
not effectively manage the interest rate risk of these securities and incurred
humungous losses when interest rates shot up. In the process, the bank lost the trust
and confidence of investors.

Additional readings on the 2023 crisis at SVB(optional):

https://finance.yahoo.com/news/why-fed-jumped-prevent-full-221301237.html

https://finance.yahoo.com/news/the-roles-goldman-sachs-played-in-the-final-days-
of-silicon-valley-bank-000951274.html

https://www.wsj.com/articles/how-goldmans-plan-to-shore-up-silicon-valley-bank-
crumbled-96bb44bb

https://www.cnbc.com/2023/03/10/silicon-valley-investors-and-founders-express-
shock-at-svb-collapse.html

https://www.washingtonpost.com/us-policy/2023/03/14/72-hour-scramble-save-
united-states-banking-crisis/

MATURITY TRANSFORMATION

Although retail deposits are payable on demand, considering the dangers of liquidity
risk as discussed above, banks should at least try and match the maturity profile of
their assets and liabilities. For example:
• Fund 1 year loans with 1 year deposits
• Fund 10 year housing loans with 10 year deposits.

But banks run a mismatch on this count

• Banks borrow for the short term and lend for the long term, incurring liquidity
risk in the process.

Why do banks do that?

A significant reason is term structure of interest rates, reflected in shape of the yield
curve.
The TERM STRUCTURE of interest rates:
• Long term rates are higher than short term rates

The yield curve reflecting the term structure of interest rates shows the yield on
bonds over different terms to maturity. The classic yield curve is upwardly sloping,
with lower rates at the short end and higher rates at the long end of the curve.

This provides an incentive for banks to

• borrow for short tenor, at a lower cost, and
• lend for long tenor, at a higher yield, thereby earning a profit/spread.

A consequence of this, is the mismatch between the maturity profile of assets and
liabilities, resulting in liquidity risk.

One of the reasons why banks exist is to undertake MATURITY TRANSFORMATION

i.e., transform short term liabilities into long term assets.

• By funding long term assets/loans with short term liabilities/deposits, banks

incur liquidity risk.

MEASURING LIQUIDITY RISK THROUGH GAP ANALYSIS

The Reserve Bank of India expects banks to draw up a daily statement classifying
maturing assets and liabilities into various time bands, and calculating the mismatch
(or gap) between outflows and inflows in each band.

• Cash outflow: A maturing liability(e.g., a deposit due to an investor)

• Cash inflow: A maturing asset(e.g., a loan instalment due from a borrower)
The time bands as per RBI guidelines are:

Outflows

For example, if a bank has total outstanding deposits of Rs 100 today, of which
• Rs 3 is maturing tomorrow: So Rs 3, will be the outflow in the day 1 time band
• Rs 5 is maturing three days from today: So Rs 5 will be the outflow in the “2-7”
day time band.
• Rs 92 is maturing in the other time bands

Inflows

If the bank has total outstanding loans of Rs 100 today, of which

• Rs 1, is maturing tomorrow: So Rs 1, will be the inflow in the day 1 band
• Rs 12 is maturing four days from today: So Rs 12 will be the outflow in the “2-
7” day band.
• Rs 87 is maturing in other time bands

Mismatch/gap=Inflows minus outflows

In the above example,

• Day 1 mismatch= Rs minus 2 i.e., negative mismatch
• “2-7 days” band mismatch = Rs 7 i.e., positive mismatch

Inflows will also include others like maturing investments in the respective time
bands and outflows will include maturing borrowings.

The most critical time band is day1/NEXT DAY, which banks need to focus on.
• According to RBI guidelines, the negative mismatch during the day1/NEXT DAY
time band should not exceed 5% of the cash outflow in that time band.

In the above example,

• Mismatch during the day1/NEXT DAY band= minus 2
• Cash outflow in the day 1/band=3

Negative mismatch/cash flow=2/3=67%.

This far exceeds the RBI limit of 5% in this hypothetical scenario !
 • However, if the bank’s deposit base is largely retail/small value deposits
instead of wholesale/bulk deposits, the bank may not have a significant
liquidity issue as majority of the retail deposits are likely to be rolled
over/renewed on maturity(day 1 in this case). Retail deposits are sticky in
nature.

RBI guidelines for the next 3 bands: the net cumulative negative mismatches during
the “2-7 days”, “8-14 days” and “15-28 days” bands should not exceed 10%, 15 %
and 20 % of the cumulative cash outflows in the respective time bands.

Banks, however, are expected to monitor their cumulative mismatches across all time
bands by establishing internal prudential limits with the approval of the Board /
Management Committee.

3) HOW CAN BANKS FINANCE THE MISMATCH/GAP?

a) Borrow from other banks in the interbank call money market. In the call money
market, a bank with a temporary shortfall can borrow from a bank with a surplus, on
an overnight basis: borrowed funds have to be repaid the next day.

b) Borrow from RBI through Repo or Marginal Standing Facility(MSF) by pledging

government securities
• RBI provides an emergency window to banks in the form of Marginal Standing
Facility (MSF), for borrowing up to a specified extent, by dipping into the SLR
portfolio i.e., breaching the minimum SLR requirement of 18%, up to 2%.

c) Borrow from the money market through TREPS (Tri party repo system) by pledging
government securities

d) Sell liquid investments. Most banks hold surplus SLR (Statutory Liquidity Ratio)
government securities, more than the minimum requirement of 18%. These
securities can be sold for raising liquidity to manage the mismatch.

4) MANAGING LIQUIDITY RISK

The regulator of banks in India, RBI, mandates banks to adhere to two important
liquidity contingency measures, SLR and CRR.
Cash Reserve Ratio/CRR: Banks follow the fractional reserve banking model. A bank
needs to hold a fraction of its deposits with the central bank, in the form of “required
reserves” (known as CRR, Cash Reserve Ratio in India) to meet liquidity
contingencies. CRR requirement for banks is 4.5% of Net Demand and Time Liabilities
(NDTL).

CRR can be thought of as “an umbrella for a rainy day”. If there is a panic run on the
bank, the bank can withdraw the funds in its account with RBI, though it may be
breaching the CRR ratio and paying a penalty. But CRR is for meeting such
contingencies.

Banks in the US too, have to meet a similar reserve ratio requirement. But this did
not help SVB when it faced a liquidity crisis, as banks need to hold only a fraction of
their deposits as a Reserve, with the central bank.

• The fractional reserve banking concept assumes that banks need to retain only
a small proportion of the deposits they collect from customers, since it is
expected that all depositors will very rarely try to get their money back at the
same time.

• This works well in normal conditions. But in times of stress at a bank(as at

SVB), if all the depositors rush to withdraw their money, fractional banking
theory fails spectacularly!

So, is there an alternative to fractional reserve banking?

An interesting quote in this context from the former war time Prime Minister of
Britain, Winston Churchill:
• Fractional reserve banking is the worst form of banking, except for all the
other forms that have been tried from time to time(!).

SLR
In addition to CRR under fractional reserve banking, banks have to maintain Statutory
Liquidity Ratio (SLR), in the form of cash, gold or government securities. SLR
requirement for banks is 18% of Net Demand and Time Liabilities (NDTL).

In general banks manage liquidity risk by

• Holding liquid investments: most banks hold surplus SLR securities.
 o For example, India’s largest bank SBI holds several lakh crores of
Government Securities in excess of the mandatory 18% SLR. These
securities can be sold(or pledged) in the market for raising liquidity.
• Maintaining regular presence in the call money market by borrowing and
lending.
• Maintaining high reputation with depositors and the market

BASEL COMMITTE RECOMMENDATIONS: LIQUIDITY COVERAGE RATIO (LCR)

ONE OF THE LESSONS OF THE 2007-8 FINANCIAL CRISIS WAS THAT SOME BANKS HAD
ADEQUATE CAPITAL BUT FACED LIQUIDITY ISSUES.

LIQUIDITY COVERAGE RATIO (LCR) was therefore proposed in Basel III as part of the
international framework for mitigating excessive liquidity risk and maturity
transformation.

LCR=Stock of High-quality liquid assets (HQLA) divided by

Total net cash outflows over the next 30 calendar days
• A bank should maintain LCR of greater or equal to 100%

The LCR standard aims to ensure that a bank

• has an adequate stock of HQLA that consists of cash, or assets that can be
converted into cash at little or no loss of value - the numerator of LCR
• to meet its liquidity needs for a 30-calendar day liquidity stress scenario-the
denominator of LCR

Objective
• To promote short-term resilience of a bank’s liquidity risk profile by ensuring
that it has sufficient HQLA to survive a significant stress scenario lasting for
one month(run on the bank!)
• Within the 30 day time it is assumed that appropriate corrective actions can
be taken by management and supervisors, or that the bank can be resolved in
an orderly way.

What constitutes HQLA, the numerator of LCR?

• Cash with a bank(currency and coins)

 • Balance kept by the bank with the central bank/RBI(in excess of CRR
requirement).
• Investment in government securities by a bank
• Investment in marketable securities issued by public sector entities with 20%
risk weightage: 85%(i.e., 85% of the investment will be factored for calculating
LCR)
• Investments in corporate securities(excluding NBFCs), to the following extent:
o AA minus and higher rating: 85% (i.e., 85% of the investment will be
factored for calculating LCR)
o Rated between A+ and BBB minus: 50%
• Equity shares included in Nifty index or BSE Sensex index.: 50% (i.e., 50% of
the investment will be factored for calculating LCR)
Others too

Total net cash outflows over the next 30 calendar days(the denominator of LCR)
• Total expected cash outflows minus
• Total expected inflows

The amount of inflows that can offset outflows is capped at 75% of total expected
cash outflows.

Cash inflows: maturing loans(including interest payments) and investments over the
next 30 days, subject to certain caps.

What constitutes expected cash outflows over the 30 day scenario?

Deposits and other borrowings of the bank maturing in the next 30 days to the extent
below, broadly classified into retail and wholesale funding:

RETAIL FUNDING

1)Retail deposits(salary accounts) which are fully insured: 5% run off. They are
expected to stay with the bank to the extent of 95% even though
• They are maturing in this 30 day period
• The scenario assumed is one of stress
Reason: retail deposits are sticky: although they are maturing during this 30 day
period, most of them(95%) are expected to be renewed/rolled over and will stick
with the bank.
• Hence 5% of deposits in this category is added to the denominator for LCR
calculation.
2)Retail deposits that are not fully covered by deposit insurance scheme or high-
value deposits, or deposits from high net worth individuals:10% run off. These are
expected to stay with the bank to the extent of 90%.
• Hence 10% of deposits in this category is added to the denominator for LCR
calculation.
✓ Unfortunately, in the 2023 bank run at a US bank(Signature Bank) this did
not hold true. The high net worth depositors fled the bank en masse:
almost 100% instead of the expected 10% run off.

WHOLESALE FUNDING

1)Deposits from small business customers: 5-10% run off depending on whether
deposits are insured.

2)Unsecured funding from non-financial corporate entities: 40% run off, i.e., 60% is
expected to stay with the bank.
• Hence 40% of deposits in this category is added to the denominator for LCR
calculation.
✓ In SVB case, almost 100% fled/attempted to flee the bank as discussed in
the earlier pages.

3)Unsecured funding from financial entities: 100% run off.

These are borrowings from other banks, financial institutions, insurance companies,
securities firms etc.
✓ 100% of borrowings in this category is added to the denominator for LCR
calculation.

Summary: a bank should rely on stable retail deposits. A bank which is relying on
wholesale/bulk deposits from corporate entities and financial entities will be much
more vulnerable to bank runs. This is reflected in the LCR calculation methodology.

Frequency of LCR calculation and reporting

The LCR should be used on an ongoing basis to help monitor and control liquidity risk.
The LCR should be reported to supervisors(RBI in India) at least monthly. Banks
should also notify supervisors immediately if their LCR has fallen, or is expected to
fall, below 100%.
LCR during a period of financial stress
During a period of financial stress, however, banks may use their stock of HQLA (to
meet their liquidity needs), thereby falling below 100%, as maintaining the LCR at
100% under such circumstances could produce undue negative effects on the bank
and other market participants. Banks should immediately report to RBI such use of
stock of HQLA along with reasons for such usage and corrective steps initiated to
rectify the situation.

The Basel Committee and RBI have one more standard for liquidity risk
measurement, the Net Stable Funding Ratio (NSFR) which is not in the scope of this
document.

ALM (ASSET LIABILITY MANAGEMENT) FUNCTION ADDRESSES LIQUIDITY RISK AND

INTEREST RATE RISK OF A BANK.
• Liquidity risk has been discussed in the previous pages.
• Interest risk is addressed in the following pages of this document.

INTEREST RATE RISK

Risk where changes in market interest rates affect a bank’s financial position

Changes in interest rates can impact a bank’s

- Earnings measured through TRADITIONAL GAP ANALYSIS (TGA)
- Net worth (Market Value of Equity) measured through DURATION GAP ANALYSIS
(DGA)
TRADITIONAL GAP ANALYSIS (TGA)

Banking scenario during the Covid pandemic

- fixed rate deposits
- predominantly floating rate loans
- falling interest rates (2020-21), post Covid-19 pandemic/lockdown

However, the scenario changed completely in the Financial Year 2022-23: the interest
rate cycle bottomed out, inflation was on the rise and interest rates increased
sharply.

In general, while the interest rates on term deposits are fixed, the advances/loans
portfolio of the banking system is basically floating.
• This can impact a bank's earnings, which can be measured through
TRADITIONAL GAP ANALYSIS (TGA).

As part of TGA, banks prepare a gap report by grouping rate sensitive liabilities, assets
and off-balance sheet positions into the various time bands according to:
- Residual maturity(for example, a 5 year deposit maturing in the next 15 days
will be placed in the first time band of 1-28 days shown below) or
- Next repricing period(for example, a 3 year floating rate term loan where the
interest rate reset is due 30 days from today, will be placed in the second time
band of 29 days to 3 months, shown below).
The various time bands are:
1. 1-28 days
2. 29 days and up to 3 months
3. Over 3 months and up to 6 months
4. Over 6 months and up to 1 year
5. Over 1 year and up to 3 years
6. Over 3 years and up to 5 years
7. Over 5 years and up to 7 years
8. Over 7 years and up to 10 years
9. Over 10 years and up to 15 years
10. Over 15 years
11. non-sensitive

An asset or liability is normally classified as rate sensitive if:

• within the time band under consideration, there is a cash flow. For
example, a Rs 10 lakh fixed rate term loan is maturing in 10 years, but the
monthly instalment of Rs 12,000 is due in the next 10 days: Rs12,000 cash
flow will be shown in the ‘1-28’ day time band
• the interest rate resets/reprices contractually during the interval. For
example, a five year Rs 20 lakh floating rate education loan is due for
interest rate reset in 60 days. The entire Rs 20 lakh will be shown in the ‘29
days and up to 3 months’ time band.

Therefore:
- All investments, advances/loans, deposits, borrowings, etc. that
mature/reprice within a specified time band are interest rate sensitive.
- Similarly, any principal repayment of a loan is also rate sensitive if the bank
expects to receive it within the time band. This includes final principal
payment in that time band and interim instalments (e.g., EMI due on an
education loan/car loan).

The analysis measures mismatches(gap) between rate sensitive liabilities (RSL) and
rate sensitive assets (RSA) as below.

Calculating gap
The Gap is the difference between Rate Sensitive Assets (RSA) and Rate Sensitive
Liabilities (RSL) for each time band.
The focus of the TGA is to measure the level of a bank’s exposure to interest rate risk
in terms of sensitivity of its Net Interest Income (NII) to interest rate movements over
the horizon of analysis which is usually one year.

To summarise, it involves:
- banding of all Rate Sensitive Assets (RSA) and Rate Sensitive Liabilities (RSL)
and off-balance sheet items as per residual maturity/ re-pricing date into
various time bands (as in above table) and
- computing Earnings at Risk (EaR) i.e., loss of income with the assumed change
in yield on 200 bps (2%) over one year.

As per RBI guidelines, each bank should set appropriate internal limits on Earnings at
Risk (EaR) with the approval of its Board.

Please refer the ALM XL sheet for numerical illustration of TGA.

POINTS TO NOTE
1)The Gap report indicates whether the bank is in a position to benefit from rising
interest rates by having a positive Gap (RSA > RSL) or whether it is in a position to
benefit from declining interest rates by having a negative Gap (RSL > RSA).
2) The gap can therefore be used as a measure of interest rate sensitivity.

DURATION GAP ANALYSIS (DGA)

So far, we have seen how

• Changes in interest rates impact a bank’s earnings (i.e., profits) through
changes in its Net Interest Income (NII).
✓ The interest rate risk, when viewed from this perspective is known as
'earnings perspective'
✓ This is measured through Traditional Gap Analysis (TGA).

Changes in interest rates

• also impact a bank’s Market Value of Equity (MVE) (‘equity’ would mean ‘net
worth’ in this context)
• through changes in the economic value of its interest rate sensitive assets,
liabilities and off-balance sheet positions.
 ✓ The interest rate risk, when viewed from this perspective, is known as
'economic value perspective’
✓ This is measured thru Duration Gap Analysis(DGA).

RBI expects banks to carry out both the analyses, TGA and DGA.

DURATION
Duration (also known as Macaulay Duration) of a bond is a measure of the time taken
to recover the initial investment in present value terms. Duration is the weighted
average term of a bond's cash flows. Duration is expressed in number of years.
Significance of duration:
- Duration is a measure of the sensitivity of the price of a bond to change in
interest rates.
- Higher the duration, more sensitive is the bond to interest rate changes.

Please refer the following links for better understanding of duration concept:
https://www.blackrock.com/us/individual/education/understanding-duration

https://europe.pimco.com/en-eu/resources/education/understanding-duration

Please read paragraph 27 in the below document:

https://rbidocs.rbi.org.in/rdocs/Publications/PDFs/PRI85CEC73A987F41AC89068EE7
607A8BEC.PDF

Please refer the ALM XL sheet for calculation of Duration of a bond.

MODIFIED DURATION (MD)

MD of an asset or liability measures the approximate percentage change in its value
for a 100 basis point (1%) change in the rate of interest.

Please refer the ALM XL sheet for calculation of Modified Duration.

In the example in the XL sheet, MD is 6.45
- this indicates that if interest rates increase by 1%, the bond's price will fall by
6.45%
- and vice versa.
STEPS IN DURATION GAP ANALYSIS(DGA)

1) The DGA involves placing of all Rate Sensitive Assets (RSA) and Rate Sensitive
Liabilities (RSL) of the bank as per residual maturity/ re-pricing dates into various
time bands:

1. 1-28 days
2. 29 days and up to 3 months
3. Over 3 months and up to 6 months
4. Over 6 months and up to 1 year
5. Over 1 year and up to 3 years
6. Over 3 years and up to 5 years
7. Over 5 years and up to 7 years
8. Over 7 years and up to 10 years
9. Over 10 years and up to 15 years
10. Over 15 years
11. non-sensitive

Banks are required to compile Statement of Interest Rate Sensitivity, both under TGA
and DGA, as per the above time bands.

2) DGA: computation of
• Modified Duration of RSA (MDA)
• Modified Duration of RSL (MDL)

MDA and MDL are the weighted average of the Modified Duration (MD) of items of
RSA and RSL respectively

3) Calculation of Modified Duration Gap (MDG)

MDG=MDA- (MDL * RSL/RSA)

The difference between Modified Duration of assets (MDA) and liabilities (MDL) is the
bank’s net duration(MDG).

If the net duration is positive (i.e., MDA>MDL)

• Decrease in market interest rates will increase the market value of
equity(MVE) of the bank
 • MVE decreases when rates increase

If the net duration is negative (MDL> MDA),

- MVE increases when the interest rate increases
- MVE decreases when rates decline

4) Computation of impact of changes in interest rates on the Net worth (NW)/Market

Value of Equity (MVE)
Impact on Net worth=minus MDG*RSA* ∆ i
∆ i is change in interest rate.

MDG can be used to evaluate the impact on the NW/MVE of the bank under different
interest rate scenarios.

Please refer the ALM XL sheet for illustration of impact on Net worth for 2%
increase in interest rate.

POINTS TO NOTE:

1)The estimated drop in MVE/Net worth (NW) as a result of the interest rate change
would indicate the economic impact on the bank’s NW but would not be an
accounting loss.

2) The Modified Duration Gap (MDG) reflects the degree of duration mismatch in the
RSA and RSL in a bank’s balance sheet.
• Larger this gap in absolute terms, the more exposed the bank is to interest
rate shocks.

3) ALM strategies to immunize impact on net worth through reducing MDG in the
numerical example in the ALM XL sheet:
• Reduce duration of assets by providing more floating rate loans/short term
loans
• Increase duration of liabilities by raising more long-term deposits.
• Usage of derivatives like interest rate swaps
RBI guidelines:
• 4)Banks should compute the potential fall in Net worth (NW)/Market Value of
Equity (MVE) under various interest rate scenarios.

• 5) Each bank should set appropriate internal limits on the volatility in

NW/MVE with the approval of its Board. These limits may be linked to
NW/MVE. The limits should be based on the bank’s risk bearing and risk
management capacity, with prior approval of its Board / Risk Management
Committee of the Board.

• 6) A level of interest rate risk, which generates a drop in the NW/MVE of more
than 20 per cent with an interest rate shock of 200 basis points(2%), is treated
as excessive, and such banks may be required by the RBI to hold additional
capital.

7) Basel Committee norms: banks to disclose impact on earnings and economic value
(Net worth) under various interest rate shock scenarios.

2023 development
New RBI guidelines for Governance, measurement and management of Interest
Rate Risk in Banking Book
https://www.rbi.org.in/Scripts/BS_CircularIndexDisplay.aspx?Id=12456
The above is optional reading.
• The date for implementation of the new guidelines is yet to be communicated.
Until then, the extant guidelines will apply.

ALM ORGANISATION IN A BANK

The Board
The Board has overall responsibility for management of risks and decides the risk
management policy of the bank and sets limits for liquidity risk, interest rate risk and
other risks.

ASSET LIABILITY COMMITEE (ALCO)

The Asset - Liability Committee (ALCO) consisting of the bank's senior management
including the CEO, is 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
liabilities sides) in line with the bank’s budget and risk management objectives.

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.

ALCO decides
1)product pricing for both deposits and advances
2)desired maturity profile and mix of the incremental assets and liabilities, etc.
3)funding mix between
• fixed vs floating rate funds
• wholesale vs retail deposits
• money market vs capital market funding
• domestic vs foreign currency funding, etc.
The ALCO would also articulate the current interest rate view of the bank and base its
decisions for future business strategy on this view.

TREASURY
While ALCO is the decision-making authority, TREASURY manages liquidity risk and
interest rate risk on the bank's balance sheet.

NOTE: the processes/terminology can vary from bank to bank.

HDFC Bank’s March 2022 Basel III - Pillar 3 Disclosures.

A very informative document, but reading is optional.
Please refer section 9 on Asset Liability Management (‘ALM’) Risk Management:
(In the document, Interest Rate Risk in Banking Book is referred to as IRRBB)
https://www.hdfcbank.com/content/api/contentstream-id/723fb80a-2dde-42a3-
9793-7ae1be57c87f/03dd1192-c7e7-4703-9647-
92e6eb86335e?#/Footer/Resource/Regulatory%20Disclosures/Content/2022/Basel-
III-Pillar-3-Disclosures-as-at-March-31-2022.pdf

The contents of this document explain the various processes and calculations in a simple to
understand manner. It does not purport to cover applicable laws and regulations in detail.
Terminology and processes are likely are likely to vary from bank to bank.
Please refer detailed RBI guidelines for managing liquidity risk and interest rate risk
available in the below links(these are not required readings):

RBI guidelines on ALM:

https://rbidocs.rbi.org.in/rdocs/notification/PDFs/5212.pdf

https://rbidocs.rbi.org.in/rdocs/notification/PDFs/80878.pdf

https://rbidocs.rbi.org.in/rdocs/notification/PDFs/10963.pdf

https://rbidocs.rbi.org.in/rdocs/notification/PDFs/COVER41110.pdf

LCR(Liquidity Coverage Ratio)

https://rbidocs.rbi.org.in/rdocs/content/pdfs/CA09062014_A.pdf

Basel Committee recommendation on Liquidity Coverage Ratio and liquidity risk

monitoring tools
https://www.bis.org/publ/bcbs238.pdf

THIS DOCUMENT IS NOT FOR CIRCULATION