Asset Liability Management in Banks

1. INTRODUCTION
Asset Liability management is very much importance for a bank. Banks are making profit from various services provided to their customers. Banks profit is functions of revenue earned form the assets and the cost incurred for the liability that has occurred for acquiring funds for financing the assets. Proper management of bank assets and liabilities can increase the profitability of the bank. The fuming of these loans and advances and investments comes from liability. So the earnings of a bank ultimately depend on liabilities. Banks have to incur costs for its liability. For example, they have to give interest to the public and also to the lending institutions. So banks liability is not cost free. Efficient use of liabilities depends on effective liability management. Effective liability management indicates that the cost of the liability will be less and also it will less volatile. But less cost and less volatility is inversely related. If we give our concentration only to less cost fund, then the funds will be volatile. Again if we give our attention to only to less volatility, then the cost of fund will be high because only the fixed deposit has the characteristics of less volatility. So we have to make coordination between least costs fund and least volatile fund. ALM has mainly two components. One is asset management and the other is liability management. Asset management deals with how a manager can appropriately handle the assets of the bank and efficiently use the profitable opportunities. On the other hand, liability management deals with the liability side of the balance sheet. A banks earning or spread is the difference between the revenue generated mainly from the asset side of the business and expense generated mainly from the liability side of the business. The foal of liability management is to gain control over the banks funds sources. Almost in every moment in our life we are confronted with different types of risk. Human mind is programmed to learn to manage risk. Managing risk is unique and fundamental in banking industry, because unlike other industry it is exposed to multi-dimensional risks that has aggravated with the advent of deregulation and globalization. No banking industry in the world is isolated from the risks, and in this

Asset Liability Management in Banks

project paper my efforts should concentrate on understanding and appreciating these risks specially managing asset and liability so that I can learn more how can manage them efficiently, appropriately and in a timely manner.

Asset Liability Management in Banks

2. ASSET LIABILITY MANAGEMENT

As financial intermediaries banks are known to accept deposit to lend money to entrepreneurs to make profit. They essentially intermediate between the opposing liquidity needs of depositors and borrowers. In the process, they function with an embedded mismatch between highly liquid liabilities on the one side and less liquid and long term assets on the other side of their balance sheets. Over and above this balance sheet conflict, they also stand exposed to a wide array of risk such as market risk, transformation risk, credit risk, liquidity risk, forex risk, legal risk, operation risk, reputational risk, interest rate risk, etc. The recognition of three main risk i.e. Interest Rate Risk, Liquidity Risk and Credit Risk gave rise to the concept of Asset Liability Management. Asset-Liability Management (ALM) can be termed as a risk management technique designed to earn an adequate return while maintaining a comfortable surplus of assets beyond liabilities. Banks are exposed to several risks which are multi-dimensional. The main direct financial risks are interest rate risk, liquidity risk, credit risk and market risk. The initial focus of the ALM function would be to enforce the risk management discipline viz. managing business after assessing the risks involved. The objective of good risk management programmes should be that these programmes will evolve into a strategic tool for bank management. The asset-liability management function would involve planning, directing and controlling the flow, level, mix, cost and yield of the consolidated funds of the Bank. It takes into consideration interest rates, earning power, and degree of willingness to take on debt and hence is also known as Surplus Management. It enables banks to sustain their required growth rate by systematically managing market risk, liquidity risk, capital risk, etc. The objective of ALM is to manage risk and not eliminate it. Risks and rewards go hand in hand. One cannot expect to make huge profits without taking a huge amount of risk. The objectives do not limit the scope of the ALM functionality to mere risk assessment, but expanded the process to the taking on of risks that might conceivably result in an increase in economic value of the balance sheet.

Asset Liability Management in Banks

Apart from managing the risks ALM should enhance the net worth of the institution through opportunistic positioning of the balance sheet. The more leveraged an institution, the more critical is the ALM function with enterprise.

The objectives of Asset-Liability Management are as follows:

To protect and enhance the net worth of the institution. Formulation of critical business policies and efficient allocation of Capital. To increase the Net Interest Income (NII) It is a quantification of the various risks in the balance sheet and optimizing of profit by ensuring acceptable balance between profitability, growth and risks. ALM should provide liquidity management within the institution and choose a model that yields a stable net interest income consistently while ensuring liquidity. To actively and judiciously leverage the balance sheet to stream line the management of regulatory capital. Funding of banks operation through capital planning. Product pricing and introduction of new products. To control volatility of market value of capital from market risk. Working out estimates of return and risk that might result from pursuing alternative programs.

Asset Liability Management in Banks

3. COMPONENTS OF FINANCIAL STATEMENT

3.1 Balance Sheet
Liabilities Assets Capital Cash and Bank Balances Reserves & Surplus Investments Deposits Advances Borrowings Fixed Assets Other Liabilities Other Assets Contingent Liabilities

Liabilities
1. Capital: Capital represents owners 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. 2. Reserves & Surplus: It includes Statutory Reserves, Capital Reserves, Investment Fluctuation Reserve, Revenue and Other Reserves, Balance in Profit and Loss Account 3. Deposits: This is the main source of banks funds. The deposits are classified as deposits payable on demand and time. This includes Demand Deposits, Savings Bank Deposits and Term Deposits 4. Borrowings: Borrowings include Refinance / Borrowings from RBI, Inter-bank & other institutions a) Borrowings in India i.e. Reserve Bank of India, Other Banks and Other Institutions & Agencies b) Borrowings outside India 5. Other Liabilities & Provisions: It can be grouped as Bills Payable, Interest Accrued, Unsecured redeemable bonds, and other provisions.

Asset Liability Management in Banks

Assets
1. Cash & Bank Balances: This includes cash in hand including foreign notes, balances with Reserve Bank of India in current and other accounts 2. Investments: This includes investments in India i.e. Government Securities, Other approved Securities, Shares, Debentures and Bonds, Subsidiaries and Sponsored Institutions, Others and investments abroad. 3. Advances: Bills purchased and Discounted, Cash Credits, Overdrafts & Loans repayable on demand, Term Loans, Secured by tangible assets, covered by Bank/ Government Guarantees. 4. Fixed Assets: This includes premises, land, furniture & fixtures, etc. 5. Other Assets: This includes Interest accrued, Tax paid in advance/tax deducted at source, Stationery and Stamps, Non-banking assets acquired in satisfaction of claims, Deferred Tax Asset (Net) and others. For ALM these assets and liabilities are classified into different time periods called maturity buckets, depending on maturity profile and interest rate sensitivity. As per Reserve Bank of India guidelines issued for ALM implementation in bank in 1999, there are eight time buckets T-1 to T-8 classified respectively as follows: (i) 1 to 14 days (ii) 15 to 28 days (iii) Over 3 months and upto 6 months (iv) Over 6 months and upto 1 year (v) 1 year and upto 3 years (vi) 3years and upto 5 years (vii) Over 5 years

Asset Liability Management in Banks

Assets - Repayment inflows into the Banks Cash 1-14 days buckets Excess balance over required CRR Bank Balance SLR shown under 1-14 days bucket Investments Respective maturity buckets Advances Respective maturity buckets Other Assets Respective maturity buckets
Liabilities - Repayment outflows from the Bank Captial Over 5 years bucket Reserves & Surplus Over 5 years bucket Deposits Respective maturity buckets Borrowings Respective maturity buckets Other Liabilties and provisions Respective maturity buckets Contingent Liabilities Respective maturity buckets

Contingent Liabilities
Banks obligations under Letter of Credits, Guarantees, Acceptances on behalf of constituents and Bills accepted by the bank are reflected under this heads.

3.2 Profit and Loss Account

Profit and Loss Account includes:

Income
1. Interest Earned: This includes Interest/Discount on Advances / Bills, Income on Investments, Interest on balances with Reserve Bank of India and other inter-bank funds 2. Other Income: This includes Commission, Exchange and Brokerage, Profit on sale of Investments, Profit/(Loss) on Revaluation of Investments, Profit on sale of land, buildings and other assets, Profit on exchange transactions, Miscellaneous Income

Asset Liability Management in Banks

Expenses
1. Interest Expense: This includes Interest on Deposits, Interest on Reserve Bank of India / Inter-Bank borrowings and others. 2. Operating Expense: This includes Payments to and Provisions for employees, Rent, Taxes and Lighting, Printing and Stationery, Advertisement and Publicity, etc.

Asset Liability Management in Banks

4. Rate Sensitive Assets & Rate Sensitive Liabilities

Those asset and liability whose interest costs vary with interest rate changes over some time horizon are referred to as Rate Sensitive Assets (RSA) or Rate Sensitive Liabilities (RSL). Those assets or liabilities whose interest costs do not vary with interest rate changes over some time horizon are referred to as Non Rate Sensitive Assets (NRSA) or Non Rate Sensitive Liabilities (RSL). It is very important to note that the critical factor in the classification of time horizon chosen. An asset or liability that is time sensitive in a certain time horizon may not be sensitive in shorter time horizon and vice versa. However, over a significantly long time horizon, virtually all assets and liabilities are interest rate sensitive. As the time horizon is shortened, the rate of rate sensitive to non rate sensitive assets and liabilities falls. The table below shows the classification of the assets and liabilities of the bank according to their interest rate sensitivity.

Liabilities Demand Deposits Current Accounts Money Market Deposits Short Term Deposits Short Term Savings Repo Transactions Equity

Type NRSL NRSL RSL RSL NRSL RSL NRSL

Assets Cash Short Term Securities Long Term Securities Variable Rate Loans Short Term Loans Long Term Loans Other Assets

Type NRSA RSA NRSA RSA RSA NRSA NRSA

Asset Liability Management in Banks

5. RISK ASSOCIATED WITH ASSET LIABILITY MANAGEMENT

Risk can be defined as the chance or the probability of loss or damage. In the case of banks these include credit risk, capital risk, market risk, interest rate risk, liquidity risk, operations risk and foreign exchange risks. These categories of financial risk require focus, since financial institutions like banks do have complexities and rapid changes in their operating environments.

1. Credit Risk:
The risk of counter party failure in meeting the payment obligation on the specific date is known as credit risk. Credit risk management is an important challenge for financial institutions and failure on this front may lead to failure of banks. Credit risk plays a vital role in the way banks perform. It reflects the profitability, liquidity and reduced Non Performing Assets. The other important issue is contract enforcement. Legal reforms are very critical in order to have timely contract enforcement. Delays and loopholes in the legal system significantly affect the ability of the lender to enforce the contract. The legal system and its processes are notorious for delays showing scant regard for time and money that is the basis of sound functioning of the market system. Credit Risk Management is the process that puts in place systems and procedures enabling banks to: Identify and measure the risk involved in credit proposition, both at individual transaction and portfolio level. Evaluate the impact of exposure on banks financial statements. Access the capability of the risk mitigates to hedge/insure risks. Design an appropriate risk management strategy to arrest risk mitigation.

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Asset Liability Management in Banks

2. Capital Risk:
Capital risk is the risk an investor faces that he or she may lose all or part of the principal amount invested. It is the risk a company faces that it may lose value on its capital. The capital of a company can include equipment, factories and liquid securities. Capital adequacy focuses on the weighted average risk of lending and to that extent, banks are in a position to realign their portfolios between more risky and less risky assets.

3. Market Risk:
Market risk refers to the risk to an institution resulting from movements in market prices, in particular, changes in interest rates, foreign exchange rates, and equity and commodity prices. Market risk is also referred to as systematic risk. This risk cannot be diversified. Market risk is related to the financial condition, which results from adverse movement in market prices. This will be more pronounced when financial information has to be provided on a marked-to-market basis since significant fluctuations in asset holdings could adversely affect the balance sheet of banks. The problem is accentuated because many financial institutions acquire bonds and hold it till maturity. When there is a significant increase in the term structure of interest rates, or violent fluctuations in the rate structure, one finds substantial erosion of the value of the securities held. Market risk is often propagated by other forms of financial risk such as credit and marketliquidity risks. For example, a downgrading of the credit standing of an issuer could lead to a drop in the market value of securities issued by that issuer. Likewise, a major sale of a relatively illiquid security by another holder of the same security could depress the price of the security.

4. Interest Rate Risk:

Banks in the past were primarily concerned about adhering to statutory liquidity ratio norms and to that extent they were acquiring government securities and holding it till maturity. But in the changed situation, namely moving away from administered interest rate structure to market determined rates, it becomes important for banks to equip themselves with some of these techniques, in order to immunize banks against interest rate risk.
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Interest risk is the change in prices of bonds that could occur as a result of change: n interest rates. In measuring its interest rate risk, an institution should incorporate re-pricing risk (arising from changing rate relationships across the spectrum of maturities), basis risk (arising from changing rate relationships among yield curves that affect the institutions activities) and optionality risks (arising from interest rate related options embedded in the institutions products). There are certain measures available to measure interest rate risk. These include: Maturity: Since it takes into account only the timing of the final principal payment, maturity is considered as an approximate measure of risk and in a sense does not quantify risk. Longer maturity bonds are generally subject to more interest rate risk than shorter maturity bonds.

Duration: Is the weighted average time of all cash flows, with weights being the present values of cashflows. Duration can again be used to determine the sensitivity of prices to changes in interest rates. It represents the percentage change in value in response to changes in interest rates. Dollar duration: Represents the actual dollar change in the market value of a holding of the bond in response to a percentage change in rates. Convexity: Because of a change in market rates and because of passage of time, duration may not remain constant. With each successive basis point movement downward, bond prices increase at an increasing rate. Similarly if rates increase, the rate of decline of bond prices declines. This property is called convexity.

5. Liquidity Risk: Liquidity Risk is the risk stemming from the lack of marketability of an investment that cannot be bought or sold quickly enough to prevent or minimize a

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Asset Liability Management in Banks

loss. It is usually reflected in a wide bid-ask spread or large price movements. It arises from the potential inability of the Bank to generate adequate cash to cope with a decline in deposits or increase in assets. To a large extent, it is an outcome of the mismatch in the maturity patterns of assets and liabilities. There are two types of liquidity i.e. market liquidity and funding liquidity. Liquidity risk broadly comprises three sub-types:

Funding Risk: The need to replace net outflows of funds whether due to withdrawal of retail deposits or non-renewal of wholesale funds. Time Risk: The need to compensate for non-receipt of expected inflows of funds, e.g. when a borrower fails to meet his repayment commitments. Call Risk: The need to find fresh funds when contingent liabilities become due. Call risk also includes the need to be able to undertake new transactions when desirable.

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6. Purpose of Asset Liability Mismatch

ALM is no longer a standalone analytical function. There are micro and macro level objectives of ALM. At micro level, the objective functions of the ALM are two-fold. It aims at profitability through price matching while ensuring liquidity by means of maturity matching. Price matching basically aims to maintain spreads by ensuring that the deployment of liabilities will be at a rate higher than the costs. Similarly, liquidity is ensured by grouping the assets/liabilities based on their maturing profiles. The gap is then assessed identify the future financing requirements. This ensures liquidity. However, maintaining profitability by matching prices and ensuring liquidity by matching the maturity levels is not an easy task. The following tables explain the process involved in price matching and maturity matching. At macro-level, ALM leads to the formulation of critical business policies, efficient allocation of capital and designing of products with appropriate pricing strategies.

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7. ADDRESSING THE MISMATCHES

A key issue that banks need to focus on is the maturity of its assets and liabilities in different tenors. A typical strategy of a bank to generate revenue is to run mismatch, i.e. borrow short term and lend longer term. However, mismatch is accompanied by liquidity risk and excessive longer tenor lending against shorter-term borrowing would put a banks balance sheet in a very critical and risky position. To address this risk and to make sure a bank does not expose itself in excessive mismatch, a bucket-wise (e.g. next day, 2-7 days, 7 days-1 month, 1-3 months, 3-6 months, 6 months-1 year, 1-2 year, 2-3 years, 3-4 years, 4-5 years, over 5 year) maturity profile of the assets and liabilities is prepared to understand mismatch in every bucket. However, as most deposits and loans of a bank matures next day (call, savings, current, overdraft etc.), bucket-wise assets and liabilities based on actual maturity reflects huge mismatch; although all of the shorter tenor assets and liabilities will not come in or go out of the banks balance sheet. As a result, banks prepare a forecasted balance sheet where the assets and liabilities of the nature of current, overdraft etc. are divided into core and non-core balances, where core is defined as the portion that is expected to be stable and will stay with the bank; and non-core to be less stable. The distribution of core and noncore is determined through historical trend, customer behavior, statistical forecasts and managerial judgment; the core balance can be put into over 1 year bucket whereas non-core can be in 2-7 days or 3 months bucket.

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8. Elements of Asset Liability Management

There are nine elements related to ALM and they are as follows: 1. Strategic framework: The Board of Directors are responsible for setting the limits for risk at global as well as domestic levels. They have to decide how much risk they are willing to take in quantifiable terms. Also it is necessary to determine who is in charge of controlling risk in the organization and their responsibilities. 2. Organizational framework: All elements of the organization like the ALM Committee, subcommittees, etc., should have clearly defined roles and responsibilities. ALM activities should be supported by the top management with proper resource allocation and personnel committee. 3. Operational framework: There should be a proper direction for risk management with detailed guidelines on all aspects of ALM. The policy statement should be well articulated providing a clear direction for ALM function. 4. Analytical framework: Analytical methods in ALM require consistency, which includes periodic review of the models used to measure risk to avoid miscalculation and verifying their accuracy. Various analytical components like Gap, Duration, Stimulation and Value-at-Risk should be used to obtain appropriate insights. 5. Technology framework: An integrated technological framework is required to ensure all potential risks are captured and measured on a timely basis. It would be worthwhile to ensure that automatic information feeds into the ALM systems and he latest software is utilized to enable management perform extensive analysis, planning and measurement of all facets of the ALM function.

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6. Information reporting framework: The information reporting framework decides who receives information, how timely, how often and in how much detail and whether the amount and type of information received is appropriate and necessary for the recipients task. 7. Performance reporting framework: The performance of the traders and business units can easily be measured using valid risk measurement measures. The performance measurement considers approaches and ways to adjust performance measurement for the risks taken. The profitability of an institution comes from three sources: Asset, Liabilities and their efficient management. 8. Regulatory compliance framework: The objective of regulatory compliance element is to ensure that there is compliance with the requirements, expectations and guidelines for risk based capital and liquidity ratios. 9. Control framework: The control framework covers the control over all processes and systems. The emphasis should be on setting up a system of checks and balances to ensure the integrity of data, analysis and reporting. This can be ensured through regular internal / external reviews of the function.

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9. THREE PILLARS OF ALM

The three pillars of Asset-Liability Management are as follows: 1. ALM Information Systems 2. ALM Organization 3. ALM Process

Pillar 1: ALM Information System

It includes Management Information System, Information availability, accuracy, adequacy and expediency. A good information system gives the bank management a complete picture of the bank's balance sheet. 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 behavioral 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. analyzing the behavior 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 centralized 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 computerization will also help banks in accessing data.

Pillar II: ALM Organization

The board should have overall responsibility for the management of risks and should decide the risk management policy of the bank and set the limits for liquidity, interest rate, foreign exchange and equity price risk. The responsibility of ALM is on the treasury department of the banks. The results of balance sheet analysis along with recommendations is place in Asset Liability Committee (ALCO) meeting by the

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treasurer where important decisions are made are made to minimize risk and maximize returns. The Alco committee comprising of the senior management of bank is responsible for Balance Sheet risk management. The size of ALCO varies from organization to organization. CEO heads the committee. The objective of the ALCO is to derive the most appropriate strategy for the banks in terms of the mix of assets and liabilities given its expectation for the future and the potential consequences of interest-rate movements, liquidity constraints, foreign exchange exposure and capital adequacy. It is the responsibility of the committee to ensure all strategies conform to the banks risk appetite and levels of exposure as determined by the Board Risk Committee.

Pillar3: ALM Process

The basic ALM processes involving identification, measurement and management of risk parameter .The RBI in its guidelines has asked Indian banks to use traditional techniques like Gap Analysis for monitoring interest rate and liquidity risk. However RBI is expecting Indian banks to move towards sophisticated techniques like Duration, Simulation, and VAR in the future. For the accrued portfolio, most Indian Private Sector banks use Gap analysis, but are gradually moving towards duration analysis. Most of the foreign banks use duration analysis and are expected to move towards advanced methods.

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10. ASSET LIABILITY COMMITTEE ALCO

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 liabilities sides) in line with the bank's budget and decided risk management objectives. The ALM desk consisting of operating staff should be responsible for analyzing, 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.

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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 computerization. Some banks may even have subcommittees. The size (number of members) of ALCO would depend on the size of each institution, business mix and organizational complexity.

Committee composition
Permanent members:

Chairman Managing Director/CEO Financial Director Risk Manager Treasury Manager ALCO officer Divisional Managers Economist Risk Consultants

By invitation:

Purposes and Tasks of ALCO:

Formation of an optimal structure of the Banks balance sheet to provide the maximum profitability, limiting the possible risk level; Control over the capital adequacy and risk diversification; Execution of the uniform interest policy; Determination of the Banks liquidity management policy; Control over the state of the current liquidity ratio and resources of the Bank; Formation of the Banks capital markets policy;

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Control over dynamics of size and yield of trading transactions (purchase/sale of currency, state and corporate securities, shares, derivatives for such instruments) as well as extent of diversification thereof; Control over dynamics of the basic performance indicators (ROE, ROA, etc.) as prescribed in the Bank's policy.

10.1 Process of ALCO

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10.2 Organization Structure of ALCO

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11. ALM APPROACH

ALM in its most apparent sense is based on funds management. Funds management represents the core of sound bank planning and financial management. Although funding practices, techniques, and norms have been revised substantially in recent years, it is not a new concept. Funds management is the process of managing the spread between interest earned and interest paid while ensuring adequate liquidity. Therefore, funds management has following three components, which have been discussed briefly.

1. LIQUIDITY RISK MANAGEMENT

Banks liquidity management is the process of generating funds to meet contractual or relationship obligations at reasonable prices at all times. New loan demands, existing commitments, and deposit withdrawals are the basic contractual or relationship obligations that a bank must meet.

Liquidity Tracking
Measuring and managing liquidity needs are vital for effective operation of the Company. By assuring the Companys ability to meet its liabilities as they become due, liquidity management can reduce the probability of an adverse situation. The importance of liquidity transcends individual institutions, as liquidity shortfall in one institution can have repercussions on the entire system. The ALCO should measure not only the liquidity positions of the Company on an ongoing basis but also examine how liquidity requirements are likely to evolve under different assumptions. Experience shows that assets commonly considered being liquid, such as govt. securities and other money market instruments, could also become illiquid when the market and players are unidirectional. Therefore, liquidity has to be tracked through maturity or cash flow mismatches. For measuring and managing net funding requirement, the use of a maturity ladder and calculation of cumulative surplus or deficit of funds at selected maturity dates is adopted as a standard tool.

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Analysis of following factors throws light on a banks adequacy of liquidity position:

a. b. c. d. e. f. g. h. 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 Present and planned capital position

To satisfy funding needs, a bank must perform one or a combination of the following:
a. b. c. d. e. Dispose off liquid assets Increase short term borrowings Decrease holding of less liquid assets Increase liability of a term nature Increase Capital funds

Statement of Structural Liquidity

It Places all cash inflows and outflows in the maturity ladder as per residual maturity. Maturity Liabilities are cash outflow and Maturity Assets are cash inflows. The mismatches in the first two buckets cannot exceed 20% of outflows. It shows the structure as of a particular date. Banks can fix the tolerance level for other maturity buckets.

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Assets and Liabilities to be reported as per their maturity profile into 8 maturity buckets:
a. b. c. d. e. f. g. h. 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

Addressing the Mismatches

Mismatches can be positive or negative 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.

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 crores over 5 years maturities and invest it in securities of 1-29 days of Rs 200 crores and rest matching with other out flows.

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2. ASSET MANAGEMENT
Many banks (primarily the smaller ones) tend to have little influence over the size of their total assets. Liquid assets enable a bank to provide funds to satisfy increased demand for loans. But banks, which rely solely on asset management, concentrate on adjusting the price and availability of credit and the level of liquid assets. However, assets that are often assumed to be liquid are sometimes difficult to liquidate. For example, investment securities may be pledged against public deposits or repurchase agreements, or may be heavily depreciated because of interest rate changes. Furthermore, the holding of liquid assets for liquidity purposes is less attractive because of thin profit spreads. Asset liquidity, or how "salable" the bank's assets are in terms of both time and cost, is of primary importance in asset management. To maximize profitability, management must carefully weigh the full return on liquid assets (yield plus liquidity value) against the higher return associated with less liquid assets. Income derived from higher yielding assets may be offset if a forced sale, at less than book value, is necessary because of adverse balance sheet fluctuations. Seasonal, cyclical, or other factors may cause aggregate outstanding loans and deposits to move in opposite directions and result in loan demand, which exceeds available deposit funds. A bank relying strictly on asset management would restrict loan growth to that which could be supported by available deposits. The decision whether or not to use liability sources should be based on a complete analysis of seasonal, cyclical, and other factors, and the costs involved. In addition to supplementing asset liquidity, liability sources of liquidity may serve as an alternative even when asset sources are available.

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3. LIABILITY MANAGEMENT
Liquidity needs can be met through the discretionary acquisition of funds on the basis of interest rate competition. This does not preclude the option of selling assets to meet funding needs, and conceptually, the availability of asset and liability options should result in a lower liquidity maintenance cost. The alternative costs of available discretionary liabilities can be compared to the opportunity cost of selling various assets. The major difference between liquidity in larger banks and in smaller banks is that larger banks are better able to control the level and composition of their liabilities and assets. When funds are required, larger banks have a wider variety of options from which to select the least costly method of generating funds. The ability to obtain additional liabilities represents liquidity potential. The marginal cost of liquidity and the cost of incremental funds acquired are of paramount importance in evaluating liability sources of liquidity. Consideration must be given to such factors as the frequency with which the banks must regularly refinance maturing purchased liabilities, as well as an evaluation of the bank's ongoing ability to obtain funds under normal market conditions. The obvious difficulty in estimating the latter is that, until the bank goes to the market to borrow, it cannot determine with complete certainty that funds will be available and/or at a price, which will maintain a positive yield spread. Changes in money market conditions may cause a rapid deterioration in a bank's capacity to borrow at a favorable rate. In this context, liquidity represents the ability to attract funds in the market when needed, at a reasonable cost vis--vis asset yield. The access to discretionary funding sources for a bank is always a function of its position and reputation in the money markets. Although the acquisition of funds at a competitive cost has enabled many banks to meet expanding customer loan demand, misuse or improper implementation of liability management can have severe consequences. Further, liability management is not riskless. This is because concentrations in funding sources increase liquidity risk. For example, a bank relying heavily on foreign interbank deposits will experience funding problems if overseas markets perceive instability in U.S. banks or the economy. Replacing foreign source funds might be difficult and costly because
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the domestic market may view the bank's sudden need for funds negatively. Again over-reliance on liability management may cause a tendency to minimize holdings of short-term securities, relax asset liquidity standards, and result in a large concentration of short-term liabilities supporting assets of longer maturity. During times of tight money, this could cause an earnings squeeze and an illiquid condition. Also if rate competition develops in the money market, a bank may incur a high cost of funds and may elect to lower credit standards to book higher yielding loans and securities. If a bank is purchasing liabilities to support assets, which are already on its books, the higher cost of purchased funds may result in a negative yield spread. Preoccupation with obtaining funds at the lowest possible cost, without considering maturity distribution, greatly intensifies a bank's exposure to the risk of interest rate fluctuations. That is why banks that particularly rely on wholesale funding sources, management must constantly be aware of the composition, characteristics, and diversification of its funding sources.

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12. Procedure for examining Asset Liability Management

In order to determine the efficacy of Asset Liability Management one has to follow a comprehensive procedure of reviewing different aspects of internal control, funds management and financial ratio analysis. Below a step-by-step approach of ALM examination in case of a bank has been outlined.

Step 1 The bank/ financial statements and internal management reports should be reviewed to assess the asset/liability mix with particular emphasis on:

Total liquidity position (Ratio of highly liquid assets to total assets). Current liquidity position (Minimum ratio of highly liquid assets to demand liabilities/deposits). Ratio of Non Performing Assets to Total Assets. Ratio of loans to deposits. Ratio of short-term demand deposits to total deposits. Ratio of long-term loans to short term demand deposits. Ratio of contingent liabilities for loans to total loans. Ratio of pledged securities to total securities.

Step 2 It is to be determined that whether bank management adequately assesses and plans its liquidity needs and whether the bank has short-term sources of funds. This should include:

Review of internal management reports on liquidity needs and sources of satisfying these needs. Assessing the bank's ability to meet liquidity needs.

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Step 3 The banks future development and expansion plans, with focus on funding and liquidity management aspects have to be looked into. This entails:

Determining whether bank management has effectively addressed the issue of need for liquid assets to funding sources on a long-term basis. Reviewing the bank's budget projections for a certain period of time in the future. Determining whether the bank really needs to expand its activities. What are the sources of funding for such expansion and whether there are projections of changes in the bank's asset and liability structure? Assessing the bank's development plans and determining whether the bank will be able to attract planned funds and achieve the projected asset growth. Determining whether the bank has included sensitivity to interest rate risk in the development of its long term funding strategy.

Step 4 Examining the bank's internal audit report in regards to quality and effectiveness in terms of liquidity management. Step 5 Reviewing the bank's plan of satisfying unanticipated liquidity needs by:

Determining whether the bank's management assessed the potential expenses that the bank will have as a result of unanticipated financial or operational problems. Determining the alternative sources of funding liquidity and/or assets subject to necessity. Determining the impact of the bank's liquidity management on net earnings position.

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Step 6 Preparing an Asset/Liability Management Internal Control Questionnaire which should include the following: 1. Whether the board of directors has been consistent with its duties and responsibilities and included:

A line of authority for liquidity management decisions. A mechanism to coordinate asset and liability management decisions. A method to identify liquidity needs and the means to meet those needs. Guidelines for the level of liquid assets and other sources of funds in relationship to needs.

2. Does the planning and budgeting function consider liquidity requirements? 3. Are the internal management reports for liquidity management adequate in terms of effective decision making and monitoring of decisions. 4. Are internal management reports concerning liquidity needs prepared regularly and reviewed as appropriate by senior management and the board of directors. 5. Whether the bank's policy of asset and liability management prohibits or defines certain restrictions for attracting borrowed means from bank related persons (organizations) in order to satisfy liquidity needs. 6. Does the bank's policy of asset and liability management provide for an adequate control over the position of contingent liabilities of the bank? 7. Is the foregoing information considered an adequate basis for evaluating internal control in that there are no significant deficiencies in areas not covered in this questionnaire that impair any controls?

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13. Regulatory Framework

The central bank of a country has to ensure that in its drive for profitability and market share the banking sector does not expose itself and by extension the market to high levels of risk. Credit risk traditionally has been and still is the biggest risk faced by this sector and has been addressed through various central bank relations and guidelines. The RBI has already come out with guidelines governing market risk including the need for banks to constitute an ALCO. However, given the state of data availability most bank ALCOs are not able to hold meaningful discussions on balance sheet risks. Discussions in most ALCOs that do meet regularly are oriented towards treasury activity rather than taking a view of the entire balance sheet. This is again mainly due to lack of data on the other businesses of the bank. However, given the increasing volatility in interest and exchange rates it is becoming critical for banks to manage their market risks. It is therefore likely that the RBI would introduce more detailed guidelines for ALM. A look at the regulatory guidelines in the more developed markets on ALM could provide clues to the main features of any guidelines that may be introduced by the RBI. 1. As a measure of liquidity management, banks are required to monitor their cumulative mismatches across all time buckets in their Statement of Structural Liquidity by establishing internal prudential limits with the approval of the Board / Management Committee. As per the guidelines, the mismatches (negative gap) during the time buckets of 1-14 days and 15-28 days in the normal course are not to exceed 20 per cent of the cash outflows in the respective time buckets. 2. Having regard to the international practices, the level of sophistication of banks in India and the need for a sharper assessment of the efficacy of liquidity management, these guidelines have been reviewed and it has been decided that : (a) The banks may adopt a more granular approach to measurement of liquidity risk by splitting the first time bucket (1-14 days at present) in the Statement of Structural Liquidity into three time buckets viz. Next day, 2-7 days and 8-14 days.

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(b) The Statement of Structural Liquidity may be compiled on best available data coverage, in due consideration of non-availability of a fully networked environment. Banks may, however, make concerted and requisite efforts to ensure coverage of 100 per cent data in a timely manner. (c) The net cumulative negative mismatches during the Next day, 2-7 days, 8-14 days and 15-28 days buckets should not exceed 5 %, 10%, 15 % and 20 % of the cumulative cash outflows in the respective time buckets in order to recognize the cumulative impact on liquidity. (d) Banks may undertake dynamic liquidity management and should prepare the Statement of Structural Liquidity on daily basis. The Statement of Structural Liquidity, may, however, be reported to RBI, once a month, as on the third Wednesday of every month. 3. The format of Statement of Structural Liquidity has been revised suitably and is furnished at Annex I. The guidance for slotting the future cash flows of banks in the revised time buckets has also been suitably modified and is furnished at Annex II. The format of the Statement of Short-term Dynamic Liquidity may also be amended on the above lines. 4. To enable the banks to fine tune their existing MIS as per the modified guidelines, the revised norms as well as the supervisory reporting as per the revised format would commence with effect from the period beginning January 1, 2008 and the reporting frequency would continue to be monthly for the present. However, the frequency of supervisory reporting of the Structural Liquidity position shall be fortnightly, with effect from the fortnight beginning April 1, 2008.

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14. ISSUES IN IMPLEMENTATION OF ALM

1. Policy:
Lack of a coherent, documented and practical policy is a big hindrance to ALM implementation. Most often, ALCO membership itself may not be aware of implications of risks being measured and impact. Policies should address all issues concerning the bank, all policies should be clearly explained to all members of board, apart from ALCO and these must be documented. Proper revisions to this document, a quarterly review needs to be organized as well as parameters may be changing due to change in situations.

2. Understanding of complexities:
Many people in a bank need to understand risk measurements and risk mitigation procedures. Measurement of risk is a fairly simple phenomenon and does go on regardless. Formalization of understanding, especially at a top level, will be helpful as it would help in decision making.

3. Organization and culture:

ALM function needs to be separated clearly from operations as it involves control and strategy functions. Risk organization in banks generally land up reporting to treasury, as they are people who come closest to understanding complex financial instruments. The fact that they are a business unit, in charge of risk taking is overlooked. Risk taking and Risk management are generally two distinct parts of any organization and both must report to a board completely independently. Openness and transparency are essential to a proper risk organization. Most organizations react badly to some positions going wrong by taking more risks and enter vicious cycle of risks. Thus, it is required to follow policy implicitly in both letter and spirit.

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4. Data and Models:

Data may not be available at all times in requisite format. It must be remembered that many data items are assumptions and gaps must be measured in perspective. There was a case of a manual branch of a bank that was closed for 6 months in a year due to inclement weather and was largely inaccessible. As data may not be obtained from this branch for 6 months, appropriate assumptions have to be made in any event. The argument is that for all other purposes, assumptions are being made. Sensible options need to be chosen and manual branch without computer was an example. However, in modern banking, it is mapping of models to zero coupon bonds that are an issue. Once again, arguments are that this should exist within the bank. Based on sophistication required, multiple models may be used to validate this conversion. This is strictly outside ALM framework but integrates into ALM framework.

5. Unrealistic goals:
An ALCO secretary was seen desperately trying to tweak with parameters to show less gaps in liquidity reports. A zero gap is not practical. Returns are expected for taking risks. Banks assume market and credit risk and hence they make returns. ALCOs job is to correctly determine positions and put in place appropriate remedial measures using appropriate risks. It is not to show things as good when they are not.

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15. TECHNIQUES OF ASEET LIABILITY MANAGEMENT

15.1 GAP Analysis Model:
Under the Gap analysis method, the various assets and liabilities are grouped under various time buckets based on the residual maturity of each item or the next reprising date, if on floating rate, whichever is earlier. Then the gap between the assets and liabilities under each time bucket is worked out. Since the objective is to maximize the NII, it will be sufficient if this is done only with respect to rate sensitive assets and liabilities. If the rate sensitive assets equal the rate sensitive liabilities, it is known as the Zero Gap or matched book position. If the rate sensitive assets are more than the rate sensitive liabilities, it is referred to as positive gap position and if the rate sensitive assets are less than the rate sensitive liabilities, it is known as negative gap position. The decision to hold a positive gap or a negative will depend on the expectation on the movement of interest rates. The effect of an upward movement or a downward movement in the interest rate on the NII will also depend on the position taken. These effects are given in the table below:

GAP Position Positive Positive Negative Negative Zero Zero

Changes in Interest Rates Increase Decrease Increase Decrease Increase Decrease

Changes in Interest Income Increase Decrease Increase Decrease Increase Decrease

Changes in Interest Expense Increase Decrease Increase Decrease Increase Decrease

Change in NII Increase Decrease Decrease Increase None None

Positive gap indicates a bank has more sensitive assets than liabilities and the NII will generally rise (fall) when interest rate rises (fall) Negative gap indicates a bank has more sensitive liabilities than assets and the NII will generally fall (rise) when interest rates rise (fall)

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It measures the direction and extent of asset-liability mismatch through either funding or maturity gap. It is computed for assets and liabilities of differing maturities and is calculated for a set time horizon. This model looks at the repricing gap that exists between the interest revenue earned and the bank's assets and the interest paid on its liabilities over a particular period of time. It is sometimes referred to as periodic gap because banks use gap analysis report to measure the interest rate sensitivity of RSA and RSL for different periods. These periods are known as maturity buckets which vary across banks, depending on the operating strategy.

Positive Gap
Rate Sensitive Assets are more than Rate Sensitive Liabilities Assets mature before Liabilities Short-term assets funded with longterm liabilities If interest rate increase, NII also increase

Negative Gap
Rate Sensitive Liabilities are more than Rate Sensitive Assets Liabilities mature before Assets Long-term assets funded with shortterm liabilities If interest rate increase, NII also decrease

Assumptions

Contractual Repayment Schedule i.e. no early repayment or option like feature On Schedule Payments i.e. there is no early repayments or defaults Parallel Shift in Yield Curve i.e. both short-term and long-term interest rate change by the same amount.

Advantages

Simple to analyze Easy to implement Helps in future analysis of Interest Rate Risk Helps in projecting the NII for further analysis

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Limitations

It does not incorporate future growth or changes in the mix of assets and liabilities. It in not take time value of money or initial net worth into account. The periods used in the analysis are arbitrary and repricing is assumed to occur at the midpoint of the period. It does not provide a single reliable index of interest rate.

Example of GAP
ABC bank for which maturity Pattern of assets and liabilities as on a particular date i.e. 31st December 2009
ABC Bank Maturity Pattern of Assets and Liabilities as on 31.12.2009 Rate Sensitive Liabilities Rate Sensitive Assets Maturity Buckets Foreign Borrow Currency ings Liabilities 0.59 0.00 8.81 5.14 3.16 23.89 2.10 0.00 43.69 Loans & Advances Foreign Investment Currency in Securities Assets 88.33 5.00 44.33 121.03 104.12 1,375.00 1,379.36 9,254.56 12,371.73 61.27 1.27 16.62 44.36 0.00 8.87 0.00 0.00 132.39

Deposits

1D - 14D 705.55 15D-28D 405.95 29D-3M 1,681.74 3M-6M 1,806.75 6M-1Y 3,955.82 1Y-3Y 7,014.37 3Y-5Y 3,807.50 5Y+ 6,085.70 Total 25,463.38

52.66 376.05 4.08 147.52 17.85 563.54 12.64 777.92 25.12 1,133.48 20.00 4,757.43 0.00 2,113.26 0.00 2,674.40 132.35 12,543.60

Here, Rs. 705.55 Cr in the deposit liability of deposits means that as on December 31st, 2009 the bank was liable to repay this amount including the interest during the next 14 days on account of the deposits received by the bank till date. Similarly, Rs. 376.05 Cr in the loans and advances indicates as on 31 st December 2009 the bank was expected to get back this amount during the next 14 days of the loans and advances it has given till date.
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Results RSL = Maturity Total Buckets Outflows 1D - 14D 15D-28D 29D-3M 3M-6M 6M-1Y 1Y-3Y 3Y-5Y 5Y+ 758.80 410.03 1,708.40 1,824.53 3,984.10 7,058.26 3,809.60 6,085.70 RSA = Total Inflows 525.65 153.79 624.49 943.31 1,237.60 6,141.30 3,492.62 11,928.96 NII = GAP GAP = GAP Ratio Cumulative I (for I = RSA = GAP 0.25% RSL RSA/RSL decrease) -233.15 -233.15 0.69 0.58 -256.24 -489.39 0.38 1.22 -1,083.91 -1,573.30 0.37 3.93 -881.22 -2,454.52 0.52 6.14 -2,746.50 -5,201.02 0.31 13 -916.96 -6,117.98 0.87 15.3 -316.98 -6,434.96 0.92 16.09 5,843.26 -591.70 1.96 1.48

Observations
From the results GAP amount is negative till 3-5 year period and positive for the last period, which means ABC bank can be grouped as liability sensitive. Longterm assets are funded with short-term liabilities and the bank will benefit as NII increases with decrease in interest rates a shown in the above table for a decrease in the rate of interest of 0.25%. Cumulative GAP amount is also negative for all time periods. GAP ratio is between 0.3 and 0.92 up to 3-5 year period indicating that inflows are always less than outflows and for the last time period inflows are double the outflows.

To reduce Rate Sensitivity

Buy long-term securities, lengthen the maturities of loan and convert floating rate loans to term loans.

To increase Asset Sensitivity

Buy short-term securities, shorten the maturities of loan and convert term loans to floating rate loans.

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To reduce Liability Sensitivity

Pay premium to attract long-term deposits and issue ling-term subordinated debt.

To increase Liability Sensitivity

Pay premium to attract short-term deposits and borrow more non-core purchased liability.

15.2 Duration Analysis:

The Gap method ignores time value of money. . Under the duration method, the effect of a change in the interest rate on NII is studied by working out the duration gap and not the gap based on residual maturity. a. Timing and the magnitude of the cash flows is ascertained and calculated. b. By using appropriate discounting factor, the present value of each of the cash flows needs to be worked out. c. The time weighted value of the present value of the cash flows is calculates. d. The sum of the time weighted value of the cash flows divided by the sum of the present values will give the duration of a particular asset. Duration analysis is useful in assessing the impact of the interest rate changes on the market value of equity i.e. asset-liability structure.

DGAP Position Positive Positive Negative Negative Zero Zero

Changes in Change in Market value Interest Assets Liabilities Equity Rates Increase Decrease Decrease Decrease Decrease Increase Increase Increase Increase Decrease Decrease Increase Decrease Increase Increase Decrease Increase Decrease Decrease None Decrease Increase Increase None

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Advantages

Duration Gap analysis serves as a strategic tool for evaluating and controlling interest rate risk. It improves the maturity gap and cumulative gap models by taking into account the timing and market value of cash flows rather them time maturity. It offers flexibility in spread management. Instead of changing the maturity structure of assets and liabilities, Duration Gap analysis puts emphasis on change of mix of assets or liabilities whichever is feasible.

Limitations

It requires extensive data on specific characteristics and current market pricing schedules of financial instruments. It requires high degree of analytical expertise regarding issues such as term structure of interest rates and yield curve dynamics.

15.3 Simulation Analysis:

It analyzes the interest-rate risk arising from both current and planned business. Gap analysis and duration analysis as stand-alone tool for asset-liability management suffer from their inability to move beyond the static analysis of current interest rate risk exposures. Basically simulation models utilize computer power to provide what if scenarios. What if: The absolute level of interest rate shift There are non parallel yield curve changes Marketing plans are under-or-over achieved Margins achieved in the past are not sustained/improved Bad Debts and prepayment levels change in the different interest rate scenarios There are changes in the funding mix e.g. an increasing reliance on short-term funds for balance sheet growth. Accurate evaluation of current exposures of asset and liability portfolios to interest rate risk.

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Changes in multiple target variables such as NII, Capital adequacy and liquidity. There are certain criteria for the simulation model to succeed. These pertain to accuracy of data and reliability of the assumptions made. In other words, one should be in a position to look at alternatives pertaining to prices, growth rates, reinvestments, etc., under various interest rate scenarios. This could be difficult and sometimes contentious. it is also to be noted that the managers might not want to document their assumptions and data is not easily available for differential impacts of interest rates on several variables. Hence, simulation models need to be used with the caution. The use of simulation model calls for commitment of substantial amount of time and resources.

Assumptions

Expected changes and the levels of interest rates and the shape of yield curve Pricing strategies for assets and liabilities The growth, volume and mix of assets and liabilities

Advantages

It is easy to approximate very complex and discounted payoffs It is very flexible It can incorporate multiple time periods It captures majority of the option risk

Limitations

It is computationally intensive It requires maintenance of pricing models

15.4 Value at Risk (VAR) Model:

Under VAR credit rating is given to each of the borrowers and its migration over the years form a part of the calculation of the credit value at risk over a given time horizon. This is due to credit risk, which emanates not only from counter party default, but also from slippage in credit quality. Thus, the volatility of value due to

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changes in the quality of the credit needs to be estimated to calculate VAR. In general; banks review financial statements of borrowers once a year and allot credit ratings. But there is no explicit theory to guide time horizon on risk assessment. Any risk assessment model shall normally predict relative risk than absolute risk. The objective of any risk assessment model is to initiate risk mitigating actions, irrespective of the time horizons. Hence, any risk measurement model can be tailored to suit different time horizons based on actual need.

Advantages

Translates portfolio exposures into potential profit and loss Aggregates and reports multi-product, multi-market exposures into one number Uses risk factors and correlations to create a risk weighted index Monitors VAR limits Meets external risk management disclosures and expectations.

Limitations

This study is useful only for normal operative accounts to predict their probability of default. This model does not take already defaulted customers into account. Macro level changes in an industry, changes in government policies, etc., may result in distorted results. In this methodology if the VAR measurement is for shorter duration, the risk assessment is more accurate.

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CONCLUSION
There is no disagreement that the performance of the commercial banks of a country should be judged in the context of the objectives of development and socioeconomic conditions prevailing in that country. At the same time, the question of cost effectiveness of the operation of the commercial banks should also be given due weightage. A bank will be cost effective, if it can collect low cost and less volatile funds and can effectively invest it in profitable secretors. For achieving the objective of cost effectiveness the banks should perform proper asset liability management. Banking has started with asset liability management. Like other financial intermediaries, commercial banks also intermediate between the savers and the borrower, to mobilize the financial surpluses of the savers and allocate these savings to the credit-worthy borrowers of different sectors in the economy. In this way, they not only help in the financial development of a country, but also facilitate the economic development. By doing this intermediation function, commercial banks are creating liability for the banks. Commercial banks are financial intermediaries who mobilize funds from surplus economic units and deploying these funds to deficit economic units. At the very beginning of the commencement of the business, commercial banks need funds for its survival. They collect funds and the again lend these funds to deficit spenders. By this way they are making profit. Banks profit is the difference between revenues earned form the lending to the deficit units and interest expense to the surplus unit. Banks can collect its funds from mainly three sources- from public as deposit, from money market borrowing and from off balance sheet sources. Among the sources, deposit source is the most costly but captures almost eighty percent share in the liability portfolio. Again deposit can be divided into three types current deposit, savings deposit and fixed deposit. Current deposit is the least costly funds of the bank. No interest cost is involved in that fund. It is generally kept by businessmen. Some administrative cost is involved in current deposit. But the problem is that current deposit is the most volatile deposit among the deposit portfolio.

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Banks are bound to refund the funds when claims are raised from depositors. It is against the principle of stability in liability management. If current deposit has the large portion in the deposit portfolio, then the bank cannot afford to go for long-term investment. Because in these cases banks may face liquidity crisis. Savings and fixed deposits are the costly sources of funds for a bank. These funds are relatively stable in nature. If bank has large portion of fixed deposit in the liability portfolio, then the bank has to incur a large volume of interest expense. Banks can also collect its necessary funds from the money market. Money market is an arrangement where the banks lend its surplus cash to other banks that need funds. The money market interest rate is generally lower than the deposit interest rate. If there is a strong money market in the economy, it reduces the dependency of bank on the costly source of fund, i.e. deposits. Commercial banks can borrow from the money market as and when required. Another important source of bank funds, which is very much popular in developed world, is the off-balance sheet source. They are asset securitization, loan selling, financial futures, interest rate options and interest rate swaps. But in our country only the traditional off-balance sheet items such as letters of credit, letter of guarantee, and bills for collection constitute an important element in the liability structure of most of the banks. Interest cost does not involve in case of off-balance sheet items. Only some administrative cost such as telephone, telegrams and stamps are involved here. When analyzing the annual report of the sampled banks, it is found that for all the banks deposit has the major contribution in the liability portfolio. The next share is for the off-balance sheet activities and money market borrowing respectively.

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BIBLIOGRAPY

Asset Liability Management in Banks ICFAI Bank Financial Management Indian Institute of Banking and Finance www.rbi.org www.investopedia.com www.allbankingsolutions.com www.iibf.org.in www.fimmda.org

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