INTRODUCTION OF ASSET-LIABILITY MANAGEMENT

In banking, asset and liability management is the practice of managing risks that arise due to mismatches between the assets and liabilities (debts and assets) of the bank. This can also be seen in insurance. Banks face several risks such as the liquidity risk, interest rate risk, credit risk and operational risk. sset !iability management ( !") is a strategic management tool to manage interest rate risk and liquidity risk faced by banks, other financial services companies and corporations. Banks manage the risks of sset liability mismatch by matching the assets and liabilities according to the maturity pattern or the matching the duration, by hedging and by securiti#ation. "uch of the techniques for hedging stem from the delta hedging concepts introduced in the Black$%choles model and in the work of &obert '. "erton and &obert . (arrow. !iquidity management is a provoking idea for the management of the financial institutions to ponder about and act. But how to act and when to act are the questions which lead to ssets and !iability "anagement ( !"), a management tool to monitor and manage various aspects of risks associated with the balance sheet management, including the management and balance sheet e)posure of the institutions. In other words, * !" is an ongoing process of formulating, monitoring, revising and framing strategies related to assets and liabilities in an attempt to achieve the financial ob+ective of ma)imi#ing interest spread or margins for a given set of risk level., It is not only a liquidity management tool, but also a portfolio management tool to alter the composition of

assets and liability portfolio to manage the risk by using various risk mitigating measures. ssets-liability management is an integral part of the planning process of commercial banks. In fact, asset-liability management may be considered as one of the three principal components of a planning system. The t !ee components are. $$ goals. $$ year. $$ %trategic planning which focuses on the long run financial and non financial aspects of a bank/s performance. DEFINITION OF ASSET-LIABILITY MANAGEMENT *If there is any area of banking that has undergone drastic change, it is the whole sub+ect of assets-liabilities management., - "a#l S$ Nadle! *%trong capital will not guarantee liquidity in all circumstances. There can be panics and sudden increase in the demand for liquidity. It is the +ob of the central banks to help in those circumstances. But a strong capital base in the system and in all its components is likely to limit future liquidity shocks. - %ean "ie!!e Landa#& De'#ty G()e!n(!& Ban* (+ F!an,e nnual profit planning and controls which focus on slightly longer term goals and look at a detailed financial plan over the course of a fiscal or calendar sset-liability management which focuses primarily on the day$to$day or week$to$week balance sheet management necessary to achieve short term financial

CONCE"T OF ALM
!" is a system of matching cash inflows and outflows in the system, and is thus a management tool of liquidity management. 0ence, if a bank meets its 'ash &eserve &atio ('&&) and %tatutory !iquidity &atio (%!&) stipulation regularly without undue and frequent resort to purchased - borrowed funds and without defaults, it can be said to have a satisfactory system of managing liquidity risks and so, of !". The spread between the deposit and lending rates were wide and also were more or less uniform and changed only at the instance of the &BI. 'learly, the institutions, themselves were not managing the balance sheet1 it was being 2managed/ and controlled through prescriptions of the regulatory authority and the government. 3ver since the initiation of the process of deregulation and liberation of interest rates and consequent in+ection of a dose of competition, the need for !" was felt. 4ith deregulation of interest rates and greater freedom being given to the organi#ations to decide and mange the cost of lending and borrowing and ultimately management of the balance sheet. 0ence, the need for a system such as !", which could provide the necessary framework to define, measure, monitor, modify and manage the interest risk. sset-liability management focuses on the net interest income if the institutions. 5et interest income is the difference between the amount of interest received from loans and investments and the amount of interest paid for deposits and other liabilities. Net inte!est in,(me - inte!est !e)en#e . inte!est e/'ense 3)pressing the net interest income as a percentage of earning allows us to e)press the interest income as a margin. The total net interest income may not be meaningfully compared between banks of different si#e but the margin may be meaningfully compared.

Net inte!est ma!gin - Net inte!est in,(me 0 ea!ning assets E1OLUTION OF ASEET- LIABILITY IN BAN2S 3ver since the initiation of the process of deregulation of the Indian banking system and gradual freeing of interest rates to market forces, and consequent in+ection of a dose of competition among the banks, introduction of asset$liability management ( !") in the public sector banks (6%Bs) has been suggested by several e)perts. But, initiatives in this respect on the part of most bank managements have been absent. This seems to have led the &eserve Bank of India to announce in its monetary and credit policy of 7ctober 899: that it would issue !" guidelines to banks. 4hile the guidelines are awaited, an informal check with several 6%Bs shows that none of these banks has moved decisively to date to introduce !". 7ne reason for this neglect appears to be a wrong notion among bankers that their banks already practice !". s per this understanding, !" is a system of matching cash inflows and outflows, and thus of liquidity management. 0ence, if a bank meets its cash reserve ratio and statutory liquidity ratio stipulations regularly without undue and frequent resort to purchased funds, it can be said to have a satisfactory system of managing liquidity risks, and, hence, of !". The actual concept of !" is however much wider, and of greater importance to banks; performance. 0istorically, !" has evolved from the early practice of managing liquidity on the bank;s asset side, to a later shift to the liability side, termed liability management, to a still later realisation of using both the assets as well as liabilities sides of the balance sheet to achieve optimum resources management. But that was till the 89:<s. In the 89=<s, volatility of

interest rates in >% and 3urope caused the focus to broaden to include the issue of interest rate risk. !" began to e)tend beyond the bank treasury to cover the loan and deposit functions. The induction of credit risk into the issue of determining adequacy of bank capital further enlarged the scope of !" in later 89=<s. In the current decade, earning a proper return of bank equity and hence ma)imisation of its market value has meant that !" covers the management of the entire balance sheet of a bank. This implies that the bank managements are now e)pected to target required profit levels and ensure minimisation of risks to acceptable levels to retain the interest of investors in their banks. This also implies that costing and pricing policies have become of paramount importance in banks. In the regulated banking environment in India prior to the 899<s, the equation of !" to liquidity management by bankers could be understood. There was no interest rate risk as the interest rates were regulated and prescribed by the &BI. %preads between the deposit and lending rates were very wide (these still are considerable)1 also, these spreads were more or less uniform among the commercial banks and were changed only by &BI. If a bank suffered significant losses in managing its banking assets, the same were absorbed by the comfortably wide spreads. 'learly, the bank balancesheet was not being managed by banks themselves1 it was being ?managed; through prescriptions of the regulatory authority and the government. This situation has now changed. The banks have been given a large amount of freedom to manage their balance sheets. But the knowledge, new systems and organisational changes that are called for to manage it, particularly the new banking risks, are still lagging. The turmoil in domestic and international markets during the last few months and impending changes in the country;s financial system are a grim warning to our bank managements to gear up their balance sheet management in a single heave. To begin with, as the &BI;s

monetary and credit policy of 7ctober 899: recommends, an adequate system of !" to incorporate comprehensive risk management should be introduced in the 6%Bs. It is suggested that the 6%Bs should introduce !" which would focus on liquidity management, interest rate risk management and spread management. Broadly, there are @ requirements to implement !" in these banks, in the stated order. 3a4 developing a better understanding of !" concepts, 3b4 introducing an !" information system, and, 3,4 setting up !" decision$making processes ( !" 'ommittee- !'7). The above requirements are already met by the new private sector banks, for e)ample. These banks have their balance sheets available at the close of every day. &epeated changes in interest rates by them during the last @ months to manage interest rate risk and their maturity mismatches are based on data provided by their "I%. In contrast, loan and deposit pricing by 6%Bs is based partly on hunches, partly on estimates of internal macro data, and partly on their competitors; rates. 0ence, 6%Bs would first and foremost need to focus son putting in place an !" which would provide the necessary framework to define, measure, monitor, modify and manage interest rate risk. This is the need of the hour.

5ISTORICAL "ERS"ECTI1E The !", historically, has evolved from the early practice of managing

liquidity on the bank/s asset side, to a later shift to the liability side and termed liability management, to a still later reali#ation of using both the assets as well as the liabilities side of the balance sheet to achieve optimum resources management, i.e., an integrated approach. 6rior to deregulation, bank funds were obtained from relatively stable demand deposits and from small time deposits. Interest rate ceiling limited the e)tent to which banks could compete for funds. 7pening more branches
6

in order to attract fresh deposits.

s a result, most sources of funds were core

deposits which were quite impervious to interest rate movements in this environment bank fund management concentrate on the control of assets. The bank/s ability to grow will be hampered if they do not have access to the funds required to create assets. They have freedom to obtain funds by borrowing from both the domestic and international markets. part of their financial management. 4ith liability management, banks now have two sources of funds A core deposits and purchased funds A with quite different characteristics. Bor core deposits, the volume of funds is relatively insensitive to changes in interest rate levels. Brom the perspective of the management, the core deposits offer the advantage of stability. 0owever core deposits have the disadvantage of not being overly responsive to management needs for e)pansion. If a bank e)periences a si#eable increase in loan demand, it can not e)pect the core deposits to increase proportionately. Bor purchased funds, however, the bank can obtain all the funds that it wants if it is willing to pay the market determined price. >nlike core deposits where the bank determines the price, the interest rates on purchased funds are set in the national money market. The bank can be thought of as a price taker in the purchased funds market whereas in the core deposit market it can be viewed as a price setter. The purchased funds give complete fle)ibility in terms of the volumes and timing of the availability of funds. s they tap different source of funds, there is an increased need for liability management and it becomes an important

MODERN "ERS"ECTI1E The recent volatility of interest rates broadened to include the issue of credit risk and market risk and to ensure that their risk management capabilities are commensurate with the risk of their business. The induction of credit risk into the issue of determining adequacy of bank capital further enlarged the scope of !". ccording to policy approach of Basel II in India, to conform to best international standards and in the process emphasis is on harmoni#ation with the international best practices. If this were so, the scope and the role of !" becomes all the more enlarged. Incidentally, commercial banks in India will start implementing Basel II with effect from "arch @8, C<<= though, as indicated by the governor of the &BI, a marginal stretching beyond this date can not be ruled out in view of latest indications of the state of preparedness. In current spell, earning a proper return for the promoter of equity and ma)imi#ation of its market value means management of the balance sheet of the institution. In other words, this also implies that managements are now e)pected to target required profit levels and ensure minimi#ation of risks to acceptable levels, to retain the interest of the investing community. In today/s competitive environment, if the organi#ation has to remain in the business, costing and product pricing policies have to be suitably structured. Thus, with the changing requirement, there is a need for not only managing the net interest margin of the organi#ation but at the same time ensuring that liquidity is managed, how much liquid the organi#ation has to be definitely, worked out on the basis of scenario analysis, but the knowledge to management, adopt the new system and organi#ational changes that are called for it to manage, have to be defined. Thus, the concept of !" is much wider and is of greater significance.

CLASSIFICATION OF ASSETS AND LIABILITIES ASSETS CLASSIFICATION LIABILITIE S AND CA"ITAL 5&% &% 5%& &% &% 5&% 5&% Eemand Eeposits 'urrent account "oney market deposits %hort term deposits !ong term savings &epo transactions equity CLASSIFICATION

Dault cash %hort term securities !ong term securities Dariable rate loans %hort term loans long term loans 7ther assets

5&%! 5&%! &%! &%! 5&%! &%! 5&%

The above table shows the classification of the assets and liabilities of a bank according to their interest rate sensitivity. Those assets and liabilities whose interest return or costs vary with interest rate changes over some time hori#on are referred to as &ate %ensitive ssets(&% ) or &ate %ensitive !iabilities(&%!). Those assets or liabilities whose interest return or costs do not vary with interest rate movements over the same time hori#on are referred to as 5on A rate %ensitive ssets (5&% ) or 5on A rate %ensitive !iabilities (5&%!). It is very important to note that the critical factor in the classification is the time hori#on chosen. n asset or liability that is time sensitive in a certain time hori#on may not be sensitive in a shorter time hori#on and vice A versa. 0owever, over a sufficiently long time hori#on, virtually all assets and liabilities are interest rate sensitive. s the time hori#on is shortened, the ratio of rate sensitive to non rate sensitive assets and
9

liabilities falls.

t some sufficiently short hori#on, say one day, virtually all assets

and liabilities are non interest rate sensitive.

ALM STRATEGY s interest rated in both the liability and the asset side were deregulated, interest rates in various market segments such as call money, 'E/s and the retail deposit rates turned out to be variable over a period of time due to competition and the need to keep the bank interest rates in alignment with market rates. 'onsequently the need to adopt a comprehensive the key ob+ectives of which were as under. The volume, mi) and cost-return of both liabilities and assets need to be planned and monitored in order to achieve the bank/s short and long term goals. "anagement control would comprehensively embrace all the business segments like deposits, borrowing, credit, investments, and foreign e)change. It should be coordinated and internally consistent so that the spread between the bank/s earnings from assets and ma)imi#ed. %uitable pricing mechanism covering all products like credit, payments, custodial financial advisory services should be put in place to cover all costs and risks. The principal purpose of asset - liability management has been to control the si#e of the net interest income. The control may be defensive or aggressive. The goal of defensive asset-liability management is to insulate the net interest income from changes in interest rates. In contrast, aggressive asset-liability the costs of issuing liabilities can be sset$ liability strategy emerged,

10

management focuses on increasing the net interest income by altering the portfolio of the institution. Both defensive and aggressive asset - liability management relate to the management of the interest rate sensitivity position of the asset and liability portfolio of the bank, and the success or failure of the strategies depend upon the effects of interest rates. Bor the success of the aggressive asset - liability management, it is necessary to forecast future interest rate changes. 7n the other hand, defensive strategy does not require the forecast of future interest rate changes. The attempt is to isolate the bank from either an increase or decrease in the rates.

ASSET MANAGEMENT STRATEGY %ome banks had the traditional deposit base and were also capable of achieving substantial growth rates in deposits by active deposit mobili#ation drive using their e)tensive branch network. Bor such banks the ma+or concern was how to e)pand the assets securely and profitably. 'redit was thus the ma+or key decision area and the investment activity was based on maintaining a statutory liquidity ratio or as a function of liquidity management. The management strategy in such banks was thus more biased towards asset management. LIABILITY MANAGEMENT STRATEGY %ome banks on the other hand were unable to achieve retail deposit growth rates since they did not have a wide branch network. But these banks possessed superior asset management skills and hence could fund assets by relying on the wholesale markets using 'all money, 'E/s Bill &ediscounting etc.

11

Eeregulation of interest rates coupled with reforms in the money market introduced by the reserve bank provided these banks with the opportunity to compete with funds from the wholesale market using the pricing strategy to achieve the desired volume, mi) and cost. %o under the !iability management approach, banks primarily sought to achieve maturities and volumes of funds by fle)ibly changing their bid rates for funds.

STRATEGIC A""ROAC5ES TO ALM Spread Management. This focuses on maintaining an adequate spread between a bank/s interest e)pense on liabilities and its interest income on assets. Gap Management. This focuses on identifying and matching rate sensitive assets and liabilities to achieve ma)imum profits over the course of interest rate cycles. Interest Sensitivity Analysis. This focuses on improving interest spread by testing the effects of possible changes in the rates, volume, and mi) of assets and liabilities, given alternative movements in interest rates. These strategies attempt to closely co$ordinate bank assets and liability management so that bank/s earnings are less vulnerable to changes in interest rates. 4e will now look at each of these strategies in a more detailed fashion.

S"READ MANAGEMENT This focuses on maintaining an adequate spread between a bank/s interest rate e)posure on liabilities and its interest rate income on assets to ensure an acceptable profit margin regardless of interest rate fluctuations. Thus spread

12

management aims to reduce the bank/s e)posure to cyclical rates and to stabili#e earnings over the long term and in order to achieve these banks must manage the maturity, rate structure and risks in its portfolios so that assets and liabilities are more or less affected equally by interest rate cycles. "aturities on assets and liabilities are either matched or unmatched. If they are matched then the bank knows what it must pay for deposits and borrowed funds and what it will earn on loans and investments. If maturities are unmatched then assets and liabilities will mature at different times and in this case management cannot lock in a spread because funds must be reinvested as assets mature and funds must be borrowed as liabilities mature at rates that may differ from current market rates. 'o$coordinating rate structure among assets and liabilities is a second most important aspect of spread management because rate structure and maturity combined determine interest sensitivity in assets and liabilities. Bor rate structure, the rates paid and earned on fi)ed$ rate assets and liabilities are not sensitive to changes in market rates because their rates are fi)ed for the term of the instrument/s maturity. Dariable rate assets and liabilities are interest sensitive because their earnings fluctuate with changing market conditions. &isk of default is the third aspect of assets and liabilities that must be coordinated in spread management. bank assumes greater risk of default in its asset portfolios than it can in its liability portfolios since the depositor/s funds need to be protected. Therefore balancing the default risk against the benefit of probable returns by assuming some risk to maintain a profitable spread is vital. Because it is difficult to forecast future rate and yield changes accurately, many banks try to match their rate sensitive assets to their rate sensitive liabilities. This approach will lead to controlled but steady growth and a gradual increase in
13

average profitability. GA" MANAGEMENT Fap management is based on the following rate mi) classifications. 1a!iable6 Interest bearing assets and liabilities whose rates fluctuates with general money market conditions. Fi/ed6 Interest bearing assets and liabilities with a relatively fi)ed rate over an e)tended period of time. Mat, ed6 %pecific sources and uses of funds in equal amounts that have predetermined maturities. By definition, gap is the amount by which the rate sensitive assets e)ceed the rate sensitive liabilities. The gap indicates the dollar amount of funds available to fund the variable rate assets with variable rate liabilities. Fap measurement allows the management to evaluate the impact the various interest rate changed will have on earnings. The ob+ective of gap management is to identify fund imbalances. Bor e)ample, If rates are declining and the banks have an e)cess of variable rate assts over fi)ed rate liabilities the bank/s rate will narrow and interest rate margin will be reduced. 7n the other hand if rates are increasing and variable rate assets e)ceed fi)ed rate liabilities the bank/s rate will widen and interest margin will increase. The gap is really a measurement of the bank/s balance sheet sensitivity to changes in the interest rates ,e)pressed as a ratio of the rate sensitive assets to rate sensitive liabilities. The greatest stability occurs when rate sensitive assets equal rate sensitive liabilities or a ratio of 8. The matched gap in the fig illustrates this position. In general, with this ratio the bank/s earnings should remain the same regardless of the interest rate
14

changes because equal amount of assets and liabilities will be repriced. Then the sensitivity ratio is greater than 8, the bank has a positive gap, or is asset sensitive. This position is illustrated by the second gap in e)hibit. If interest rates rise, the bank will benefit as more assets than liabilities are repriced at higher rates. 'onversely, if rates fall the bank/s margin will be negatively affected as more assets than liabilities will be repriced at lower rates.

INTEREST SENSITI1ITY ANALYSIS This is an e)tension of gap management. It attempts to improve the interest spread by testing the effects of changes in rates, volume, and mi) of assets and liabilities given alternative movements in interest rates. In this analysis, the bank plans from a given point in time and pro+ects possible changes in its income statement that might result if changes are made in the balance sheet. %uch changes are then tested against scenarios of rising rates and falling rates for periods ranging from two weeks to one year. The analysis begins by separating the bank/s balance sheet into fi)ed rate and variable rate components. The interest rate and margin are identified in the current year. The ne)t step lists the various assumptions that involve the rate, mi), and volume of the bank/s portfolios$ for e)ample, pro+ected increases in the volume of loans, consumer time deposits, and larger 'E/s, as well the current rates on these instruments. The remaining key assumptions reflect the possible alternative directions in which the rates may move. The bank then tests the effect of assumed changes in the volume and composition of its portfolios against both interest rate scenarios (rising and falling rates) to determine their impact on interest spread and margin.

15

0owever if the bank/s assets and liabilities are unmatched, the bank/s earnings can be protected or improved by planning courses of action in advance for periods of rising and falling rates. 0edging with futures trading is a final strategy that can be used to protect against e)posure to interest rate risk if the bank/s interest sensitive assets and liabilities are unmatched. Banks can use futures contracts as tools of !" by selling futures ( a short hedge) or buying futures (a long hedge). If the bank is in an unmatched position in which the interest sensitive assets are funded by fi)ed rate liabilities, it makes a long hedge. If the position is one of fi)ed rate assets funded by interest sensitive liabilities the bank makes a short hedge. The ability to use hedging effectively to offset risk in an unmatched position require that the future course of interest rate levels be predicted accurately.

MEASURING INTEREST RATE SENSITI1ITY The most commonly used measure of the interest rate position of a bank is Fap analysis. The Fap is the difference between the amount of the rate sensitive assets and rate sensitive liabilities. The Fap may be e)pressed in a variety of ways. The simplest is the rupee Fap A the difference between the amounts of &% which is the ratio of the rupee Fap and the Total assets. Relati)e Ga' !ati( - R#'ee Ga' 0 T(tal assets Inte!est !ate sensiti)ity !ati( - RSA 0 RSL bank at a given time may be asset or liability sensitive. If the bank were asset sensitive, it would have a positive Fap, appositive relative Fap ratio and an and &%! e)pressed in rupees. %ome other measures of Fap are the relative Fap ratio, nother measure is the interest rate sensitivity ratio, which is the ratio of the &% to &%!.

16

interest sensitivity ratio greater than one. 'onversely, a bank that is liability sensitive would have a negative Fap, a negative relative Fap ratio and interest sensitivity ratio less than one. Banks that are asset sensitive e)perience an increase in their net interest income when interest rate increase and vice A versa. 'onversely, banks that are liability sensitive see their net interest income decrease when interest rate and vice A versa. The below table summaries the effects interest rate changes on net interest income for different Fap positions.

EFFECTS OF C5ANGES IN INTEREST RATES GA" 6ositive 6ositive 5egative 5egative Gero Gero C anges in Inte!est Rate C anges in Net Inte!est Rate Increase Increase Eecrease Eecrease Increase Eecrease Eecrease Increase Increase Gero Eecrease Gero

The focus of asset-liability management is on interest rate risk. 0owever, a management is concerned with managing the entire risk profile of the institutions, including interest risk, credit risk, liquidity risk and other dimensions of risk. If those risks were unrelated, then managers could concentrate on one type of risk, making appropriate decisions and ignoring the effect of the decisions on the other types of risks. 0owever, the different types of risks have a high degree of correlation, especially the interest rate risk and the credit risk.

17

ASSET-LIABILITY MANAGEMENT "ROCESS The !" process rests on three pillars. ALM in+(!mati(n systems $ "anagement Information %ystem $ Information availability, accuracy, adequacy and e)pediency ALM (!ganisati(n $ %tructure and responsibilities $ !evel of top management involvement ALM '!(,ess $ &isk parameters $ &isk identification $ &isk measurement $ &isk management $ &isk policies and tolerance level

ALM in+(!mati(n systems Information is the key to the !" process. 'onsidering the large network of branches and the lack of an adequate system to collect information required for !" which analyses information on the basis of residual maturity and behavioural pattern it will take time for banks in the present state to get the requisite information. The problem of !" needs to be addressed by following an B' approach i.e. analysing the behaviour of asset and liability products in the top branches accounting for significant business and then making rational assumptions about the way in which assets and liabilities would behave in other branches. In respect of foreign e)change, investment portfolio and money market operations, in
18

view of the centralised nature of the functions, it would be much easier to collect reliable information. The data and assumptions can then be refined over time as the bank management gain e)perience of conducting business within an !" framework. The spread of computerisation will also help banks in accessing data.

ALM ORGANI7ATION 8 at D(es Asset-Liability Committee - ALCO Mean9 risk$management committee in a bank or other lending institution that generally comprises the senior$management levels of the institution. The !'7;s primary goal is to evaluate, monitor and approve practices relating to risk due to imbalances in the capital structure. Asset-Liability Committee - ALCO Bor e)ample, the !'7 will have responsibility for setting limits on the arbitrage of borrowing in the short$term markets, while lending long$term instruments. mong the factors considered are liquidity risk, interest rate risk, operational risk and e)ternal events that may affect the bank;s forecast and strategic balance$sheet allocations. The !'7 will generally report to the board of directors and will also have regulatory reporting responsibilities. ) The Board should have overall responsibility for management of risks and should decide the risk management policy of the bank and set limits for liquidity, interest rate, foreign e)change and equity price risks. B) The sset $ !iability 'ommittee ( !'7) consisting of the bank;s senior management including '37 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

19

the assets and liabilities sides) in line with the bank;s budget and decided risk management ob+ectives. ') The !" desk consisting of operating staff should be responsible for analysing, monitoring and reporting the risk profiles to the !'7. 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 !'7 is a decision making unit responsible for balance sheet planning from risk $ return perspective including the strategic management of interest rate and liquidity risks. 3ach bank will have to decide on the role of its !'7, 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 !'7 would consider, interalia, 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 !'7 should review the results of and progress in implementation of the decisions made in the previous meetings. The !'7 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 mi) 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 mi) between fi)ed v-s floating rate funds, wholesale v-s retail deposits, money market v-s capital market funding, domestic v-s foreign currency funding, etc. Individual banks will have to decide the frequency for holding their !'7 meetings.

20

C(m'(siti(n (+ ALCO The si#e (number of members) of !'7 would depend on the si#e of each institution, business mi) and organisational comple)ity. To ensure commitment of the Top "anagement, the '37-'"E or 3E should head the 'ommittee. The 'hiefs of Investment, 'redit, Bunds "anagement - Treasury (fore) and domestic), International Banking and 3conomic &esearch can be members of the 'ommittee. In addition the 0ead of the Information Technology Eivision should also be an invitee for building up of "I% and related computerisation. %ome banks may even have sub$committees. C(mmittee (+ Di!e,t(!s Banks should also constitute a professional "anagerial and %upervisory 'ommittee consisting of three to four directors which will oversee the implementation of the system and review its functioning periodically. FUNDAMENTAL STE"S OF AN ALM "ROCESS n effective !" process begins with the support of the entity/s senior management. 7ngoing communication is essential. The process consists of five fundamental steps. :$ ASSESS T5E ENTITY;S RIS20RE8ARD OB%ECTI1ES The purpose of !" is not necessarily to eliminate or even minimi#e risk. The level of risk will vary with the return requirement and entity/s ob+ectives. Binancial ob+ectives and risk tolerances are generally determined by senior management of an entity and are reviewed from time to time.

21

<$ IDENTIFY RIS2S ll sources of risk are identified for all assets and liabilities. &isks are broken down into their component pieces and the underlying causes of each component are assessed. &elationships of various risks to each other and-or to e)ternal factors are also identified. =$ >UANTIFY T5E LE1EL OF RIS2 E?"OSURE &isk e)posure can be quantified 8) relative to changes in the component pieces, C) as a ma)imum e)pected loss for a given confidence interval in a given set of scenarios, or @) by the distribution of outcomes for a given set of simulated scenarios for the component piece over time. &egular measurement and monitoring of the risk e)posure is required. @$FORMULATE AND IM"LEMENT STRATEGIES TO MODIFY E?ISTING RIS2S !" strategies comprise both pure risk mitigation and optimi#ation of the risk-reward tradeoff. &isk mitigation can be accomplished by modifying e)isting risks through techniques such as diversification, hedging, and portfolio rebalancing. Bor a given risk tolerance level, a given set of investment opportunities, and a given set of constraints, optimi#ation ensures that the portfolio has the most desirable risk-reward tradeoff. 7ptimi#ation presupposes that the management team has been previously educated on the risk-reward profile of the business and understands the necessity to take action based on !" analysis.

22

6ractitioners are cautioned not to put undue reliance on the results of a mechanical calculation. 6rofessional +udgment is an important part of the process. A$ MONITOR RIS2 E?"OSURES AND RE1ISE ALM STRATEGIES AS A""RO"RIATE !" is a continual process. ll identified risk e)posures are monitored and reported to senior management on a regular basis. If a risk e)posure e)ceeds its approved limit, corrective actions are taken to reduce the risk e)posure. Bor pension plans, monitoring current financial status and possible short$term outcomes is very helpful in managing pension risk. 7perating within a dynamic environment, as the entity/s risk tolerances and financial ob+ectives change, the e)isting !" strategies may no longer be appropriate. 0ence, these strategies need to be periodically reviewed and modified. formal, documented communication process is particularly important in this step.

"RINCI"LES OF ASSET-LIABILITY MANAGEMENT . ECONOMIC 1ALUE !" focuses on 3conomic Dalue. consistent !" structure can only be achieved for economic ob+ectives. 3conomic value is based on future asset and liability cash flows. !" uses these future cash flows to determine the risk e)posure and achieve the financial ob+ectives of an entity. n entity/s financial ob+ectives may include ma)imi#ing one or more of these values. economic value, accounting measures such as earnings and return on equity, or embedded value. Bor private pension plans, financial ob+ectives may
23

include the pattern of future funding requirements. Darious accounting measures are affected by rules that change the emergence of income and the reported book value of the assets and liabilities. These measures can sometimes distort economic reality and produce results inconsistent with economic value. Because !" is concerned with the future asset and liability cash flows, the natural focus of !" is economic value. ccounting measures or future funding requirements are often included as constraints within an !" framework. 3ntities that focus on economic value tend to achieve their financial ob+ectives more consistently in the long term. B$ MUTUAL DE"ENDENCE !iabilities and their associated assets are mutually dependent. "utual dependence arises in an !" conte)t because of the necessity to manage the interdependence between the asset and liability cash flows to achieve economic and financial ob+ectives. The mutual dependence principle applies to portfolios consisting of both assets and liabilities. It holds even if the assets and liabilities are affected by different economic factors, or even if asset and liability cash flows are fi)ed. "utual dependence may be greater when the performance of one portfolio affects the performance of another portfolio. Bor e)ample, the credited rate on the liabilities may influence the lapse-withdrawal rate, which in turn may require une)pected liquidation or reinvestment of assets. The mutual dependence principle implies that assets and liabilities must be managed concurrently in order to optimi#e achievement of economic and financial ob+ectives.
24

C$ DI1ERSIFICATION The level of risk associated with a given financial ob+ective can be reduced through diversification by combining e)posures that are less than 8<<H positively correlated. &isks are diversifiable through aggregation up to the point where only systematic risk remains. Bor e)ample, the return volatility of a portfolio of assets caused by changes to the level of prevailing interest rates is diversifiable through investing in different asset classes such as stocks. 0owever, the residual systematic risk cannot be diversified through simple aggregation. It can, however, be reduced through hedging. In times of significant economic turmoil asset correlations tend toward 8.< or A 8.<. This can be observed in equity market data from 7ctober 89=: or bond market data from ugust 899=. Euring such environments the risk reduction benefits of diversification may temporarily disappear. 'orrelations between asset returns may not be a constant function, but instead may vary over time and between different scenarios. "oreover, true relationships between variables may be nonlinear. The diversification principle applies to all combinations of asset and liability portfolios. D$RIS20RE8ARD TRADE-OFF Freater rewards are generally e)pected from portfolios with higher levels of risk. &ational investors e)pect greater rewards for accepting higher levels of risk. The higher$risk-greater$reward relationship may not hold if the portfolio is sub$ optimal for a given level of risk (i.e., a comparably risky portfolio has a higher return)1 if an arbitrage opportunity e)ists in the markets, or if environmental pressures affect investors/ preferences and behaviors. s a direct result of the risks
25

accepted, greater reward commensurate with higher risk levels may not be actually reali#ed. In an !" conte)t, the riskiness of a portfolio is determined by the net position of the combined assets and liabilities. E$CONSTRAINTS 3)pected risk-reward trade$off tends to worsen as more constraints are imposed and as the constraints become more restrictive. n !" framework contains internal and e)ternal constraints including investment policy requirements, rating agency e)pectations, regulatory issues, and required capital goals. Bor e)ample, an investment policy may specify that no below investment grade bonds may be purchased and bonds downgraded to below investment grade must be sold within @< days. This constraint forces a sale at a time when a bond/s price is under short$term pressure and may offer an opportunity to investors not sub+ect to this constraint. nother common e)ample of constraints within an !" conte)t is the professional +udgment constraints applied to outcomes generated by mathematical models. Bor e)ample, traditional efficient frontier analysis is e)tremely sensitive to input assumptions, and slight ad+ustments to assumptions can produce very different efficient portfolio outcomes. 6rofessional +udgment is typically applied to temper the model/s outcomes by constraining asset class allocations and forcing additional portfolio diversification. F$DYNAMIC EN1IRONMENT The risks to which an entity is e)posed and the associated rewards are determined by internal and e)ternal factors that change over time.

26

!" is an ongoing process. &isks an entity assumes and to which it is e)posed are continuously changing. Internal factors arise from the financial ob+ectives, risk tolerances, and constraints of the entity. 3)ternal factors include interest rates, equity returns, competition, the legal environment, regulatory requirements, and ta) constraints. %uch factors often impact both assets and liabilities simultaneously, although the impact is not necessarily of the same magnitude or in the same direction. Burthermore, an entity may have different risk tolerances under different circumstances and for different time hori#ons. ccordingly, analyses, conclusions, and strategies relevant to a specific point in time need to be periodically reevaluated and updated. G$UNCERTAINTY sset and liability cash flows cannot be pro+ected with certainty. The dynamic environment as well as pure randomness create uncertainties in the portfolio cash flows and, hence, in the true risk e)posure. &isks varies as the underlying risk factors (e.g., interest rates, equity returns, defaults, policyholder-customer behavior, lapses-withdrawals, pension shutdowns, etc.) change and as future e)pected cash flows are replaced by actual cash flows. This process reflects cash flows reacting to factor changes (e.g., interest$sensitive cash flows), truing up to actual e)perience, and results in revisions of future assumptions. The ultimate risk e)posure will be a function of the actual cash flows. !" requires the use of models to pro+ect future uncertain cash flows. In some cases, simple deterministic models can be used and !" can be based on one set of e)pected future cash flows. In other cases, such as when future cash flows are e)pected to depend on future economic conditions, more comple) models may be required to understand the interaction of the asset and liability cash flows.
27

%tochastic models are often used to simulate future e)pected cash flows under various scenarios to help identify the associated risk e)posures. These models produce statistical distributions of potential results and different !" strategies can be evaluated by studying the range of results produced from modeling these strategies. "odeling can also be used to construct many possible futures or scenarios, and then, results across all the scenarios can be used to measure risk in the portfolio. "odel risk is the additional risk created when the model does not adequately represent the underlying process or reality. There are two general classes of model risk. the risk of model misspecification, oversimplification, or outright errors, and the risk of a changing environment not anticipated in the model. Bor e)ample, using a lognormal model of stock market prices produces a distribution with too few e)treme value sample points (i.e., that is not *fat, enough in the tails) to adequately assess the risk for some comple) embedded options, such as guaranteed minimum death benefits. In addition, the volatility of equity returns varies over time and this may not be accurately captured in the model. 5$ 5EDGING The overall risk of a portfolio may be reduced through hedging. 0edging plays an integral role in the !" process. 7nce the risks associated with a portfolio or transaction has been identified, the e)isting risks can be modified to suit the entity/s risk tolerances and financial ob+ectives. >ndertaking additional risks that partially or fully offset the e)isting risks may accomplish this goal. 0edging may be done at either the transaction or portfolio level. 0edging may be complete or partial, perfect or imperfect (i.e., cross hedging). 0edging instruments include assets, liabilities, and derivatives. n asset with a matching liability is a natural hedge. The time hori#on over which the hedge is in place may
28

vary, but should nevertheless be e)plicitly defined. &isk can be controlled through diversification when the law of large numbers applies (e.g., when risks are diversifiable). 0edging is a strategy available to reduce risk when the law of large numbers does not operate, such as when a stock market decline results in equity$linked guarantees of an annuity block of business being in the money for every annuity contract at the same time. 0edging may reduce some risks but often introduces other risks, such as counterparty risk and basis risk. Basis risk arises from imperfect or partial hedging, where the hedging instruments are not perfectly negatively correlated with the risks being hedged. In some instances, an imperfect hedge may even increase the overall risk. s the overall risk is reduced through hedging, the e)pected reward normally decreases as well.

A""LICABILITY OF ALM "RINCI"LES

wide variety of entities are faced with !" related considerations. %uch entities include.

Insurance companies, banks and thrifts, investment firms, and

other financial services companies

6ension and trust funds (e.g., endowments and foundations) Fovernments 7ther commercial or not$for$profit enterprises

29

Individual investors

ASSET-LIABILITY MANAGEMENT IN RIS2 FRAME8OR2

Asset$!iability "anagement ( !") can be termed as a risk management technique designed to earn an adequate return while maintaining a comfortable surplus of assets beyond liabilities. It takes into consideration interest rates, earning power, and degree of willingness to take on debt and hence is also known as %urplus "anagement. But in the last decade the meaning of !" has evolved. It is now used in many different ways under different conte)ts. !", which was actually pioneered by financial institutions and banks, are now widely being used in industries too. The %ociety of ctuaries Task Borce on !" 6rinciples, 'anada, offers the following definition for !". I sset !iability "anagement is the on$going process of formulating, implementing, monitoring, and revising strategies related to assets and liabilities in an attempt to achieve financial ob+ectives for a given set of risk tolerances and constraints.I

30

CREDIT RIS2 MANAGEMENT 'redit risk management plays a vital role in the way banks perform. It reflects $ The profitability $ !iquidity $ &educed 56 s. 'redit risk management is a process that puts in place systems and procedures enabling a bank to$ $ Identify J measure the risk involved in a credit proposition, both at the individual transaction and portfolio level. $ 3valuate the impact of e)posure on bank/s financial statements. $ ssess the capability of risk mitigates to hedge- insure risks. $ Eesign an appropriate risk management strategy to arrest *risk$ migration,. 8ay +(! C!edit Ris* Management6'redit risk management is done at two levels$"icro level J "acro level. s the credit risk management at micro$level is focused on clients, the efficiency level of the operating staff in credit evaluation and monitoring needs to be honed up. In macro level approach to credit risk management, the 'apital e)posures keeping the overall position of its credit deployment. dequacy &atio (' &) plays a crucial role. The bank management stipulates the industry

31

&isk transfer is a popular risk management technique being used today. The development of credit derivatives is a logical e)tension of two of the most significant developments such as securiti#ation and derivatives. bundle of risks and returns. credit asset is a nd every asset is acquired to make certain returns.

0owever, the probability of not making the e)pected return is the default risk associated with every credit asset. 7ne of the alternatives available to a bank in managing credit risk is the use of credit derivatives. 'redit derivatives facilitate risk transfer. This concept has picked up momentum in the >% and 3uropean markets and is yet to pick up in India. 'onsidering the pathetic scenario of loan portfolio in Indian banks, our regulators can e)plore the possibilities of developing instruments facilitating credit risk transfer. LI>UIDITY RIS2 MANAGEMENT "easuring and managing liquidity needs are vital activities of commercial banks. By assuring a bank;s ability to meet its liabilities as they become due, liquidity management can reduce the probability of an adverse situation developing. The importance of liquidity transcends individual institutions, as liquidity shortfall in one institution can have repercussions (indirect effect) on the entire system. Bank management should measure not only the liquidity positions of banks on an ongoing basis but also e)amine how liquidity requirements are likely to evolve under crisis scenarios. 3)perience shows that assets commonly considered as liquid like Fovernment 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. Bor measuring and managing net funding requirements, 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.
32

The "aturity 6rofile could be used for measuring the future cash flows of banks in different time buckets. The time buckets given the %tatutory &eserve cycle of 8K days may be distributed as under. i) 8 to 8K days ii) 8L to C= days iii) C9 days and upto @ months iv) 7ver @ months and upto M months v) 7ver M months and upto 8C months vi) 7ver 8 year and upto C years vii) 7ver C years and upto L years viii) 7ver L years

Best "!a,ti,es +(! Managing LiB#idity Ris* &ecent volatility in the wholesale funding markets has served to highlight the importance of sound liquidity risk management practices and reinforce the lesson that those banks with well$ developed risk management functions are better positioned to respond to new funding challenges. The banking industry has developed many innovative solutions in response to these challenges, some of which are presented here. Because banks vary widely in their funding needs, the composition of their funding, the competitive environment in which they operate, and their appetite for risk, there is no one set of universally applicable methods for managing liquidity risk. 4hile there is little commonality in their approach to liquidity risk management, well$managed banks utili#e a common si)$step process to manage it. Meas#!ement Systems

33

"ost banking e)perts agree that maintaining an appropriate system of metrics is the linchpin upon which the liquidity risk management framework rests. If they are to successfully manage their liquidity position, management needs a set of metrics with position limits and benchmarks to quickly ascertain the bank/s true liquidity position, ascertain trends as they develop, and provide the basis for pro+ecting possible funding scenarios rapidly and accurately. In addition, the bank should establish appropriate benchmarks and limits for each liquidity measure. The varied funding needs of institutions preclude the use of one universal set of metrics. s a result, banks frequently use a combination of stock and flow liquidity measures or have gone to e)clusive reliance on models. %tock measures look at the dollar levels of either assets or liabilities on the balance sheet to determine whether or not these levels are adequate to meet pro+ected needs. Blow measures use cash inflows and outflows to determine a net cash position and any resultant surplus or deficit levels of funding. "odels are built utili#ing hypothetical scenarios to develop measures, benchmarks, and limits. Balance$sheet$based measures are generally best suited to smaller institutions which fund their business lines, generally loans, with core deposits. These banks generally develop their measurement system and their corresponding benchmarks and limits based on either selected peer group analysis or on studies of historical liquidity needs over time. In addition, most of these banks utili#e flow measures to determine their net cash position. 4hile this combination works well for smaller banks, regional and global institutions that have significant trading operations and are heavily reliant on purchased funding find that stock and flow measures are no longer adequate to meet their needs. s a result, these banks have either developed or have purchased model$based measurement systems to assist them in liquidity measurement.

34

 Im'lementati(n There is some diversity within the industry on how to implement the contingency plan. %ome banking organi#ations have developed predefined triggers that automatically implement the plan, while others rely on a set of critical warning signals that require senior management to review the situation and decide whether to implement it. To assist banks in developing their liquidity crisis warning signal criteria, the following list of the most common early warning signs is offered. NTraditional funds providers start to disappear. NIndividual deal si#es begin to decrease as funders become more conservative. NThere are difficulties accessing longer$term money (particularly over quarter$end reporting dates).N It becomes more difficult to manage rising funding costs in a stable market. N'ustomers start to cash in 'Es and other time deposit products prior to maturity. The bank begins to be closed out of some markets and is increasingly being forced to relyN on brokers. 'ounterparty resistance develops to bank off$balance sheet products. 6olicy and strategy considerations. Bunding policies and strategies should be in place to deal with various issues in a consistent manner during a liquidity crisis. %ome of these issues include. Bank and affiliate funding and off$balance sheet product strategies. NIdentification of sensitive markets to avoid. N3stablishment of formal pricing policies. N6ayout of deposit products prior to maturity.
35

 Eirect vs. broker-dealer funding methods. N"anagement of secondary market trading-discount of bank and holding company liabilityNinstruments.

CURRENCY RIS2 MANAGEMENT Bloating e)change rate arrangement has brought in its wake pronounced volatility adding a new dimension to the risk profile of banks; balance sheets. The increased capital flows across free economies following deregulation have contributed to increase in the volume of transactions. !arge cross border flows together with the volatility has rendered the banks; balance sheets vulnerable to e)change rate movements Eealing in different currencies brings opportunities as also risks. If the liabilities in one currency e)ceed the level of assets in the same currency, then the currency mismatch can add value or erode value depending upon the currency movements. The simplest way to avoid currency risk is to ensure that mismatches, if any, are reduced to #ero or near #ero. Banks undertake operations in foreign e)change like accepting deposits, making loans and advances and quoting prices for foreign e)change transactions. Irrespective of the strategies adopted, it may not be possible to eliminate currency mismatches altogether. Besides, some of the institutions may take proprietary trading positions as a conscious business strategy. "anaging 'urrency &isk is one more dimension of sset$ !iability "anagement. 6resently, the banks are also free to set gap limits with &BI;s approval but are required to adopt Dalue at &isk (Da&) approach to measure the

36

risk associated with forward e)posures. Thus the open position limits together with the gap limits form the risk management approach to fore) operations.

USING FUTURES& O"TIONS AND S8A"S %ome relatively new techniques that can be used by banks to manage their asset$liability portfolio include future, option and swaps. lthough these instruments have come into vogue in the last two decades in the >% and 3urope, they have e)perienced a tremendous growth and are becoming very significant in asset$liability management. management. The ad+ustments to the bank/s portfolio involve changing the current cash or spot market positions in the portfolio of assets and liabilities. 3quivalent ad+ustment in the bank/s interest sensitive positions can be achieved through transactions in the future markets. future contract is a standardi#ed agreement to buy or sell a specified quantity of a financial instrument on a specified future date at a set price. These future transactions in effect create synthetic positions with interest sensitivity positions different from those currently held in the portfolio. 7ne of the other ma+or techniques used to manage interest rate risk is the interest rate swap. In an interest rate swap, two firms that want to change their interest rate e)posure in different directions get together (usually through an intermediary) and e)change (swap) their obligation to pay interest. 7nly the interest is swapped and not the principal. 'ompared to futures, swaps have both
37

lthough these techniques are used primarily in

defensive asset$liability management, they can also be used in aggressive

advantages and disadvantages. Birst swaps may be customi#ed to meet the needs of the banks. %econdly, swaps can be arranged for longer terms (say @ to 8< years) whereas futures contracts are usually of shorter duration (usually under M months). %waps also have disadvantage compared to future contract. s swaps are customi#ed contracts, it involves time (and e)pense) in getting the right swap transactions. %econd due to the customi#ation, it is difficult to correctly evaluate a swap and close out a contract, compared to futures. 3qually significantly, the bank that enters into a swap agreement faces the risk of counterparty default.

LIABILITY MANAGEMENT In the broadest sense liability management involves the planning and co$ ordination of all the bank/s sources of funds in order to maintain liquidity, profitability and safety to maintain long$term growth. 3ffective liability management ensures that funds are available over the short term to meet reserve requirements and to provide adequate liquidity, and over the long term to satisfy loan demand and to provide investment earnings. The basic concerns of liability management are how a bank can best influence the volume, cost and stability of the various types of funds it can obtain. Objectives 4hen a bank needs funds to cover deposit withdrawals or ton e)pand its loans to acquire other assets, it can obtain the needed funds in two ways. 7ne way of acquiring funds is to liquidate some of the short term assets that the bank holds in units liquidity account for this purpose. bank can also obtain funds by acquiring additional liabilities i.e. by buying the funds it needs. Basically, liability management seeks to control the sources of funds that a bank can obtain quickly

38

and in large amounts, unlike demand and savings deposits, which cannot be increased to any great degree over a short time period. Eepending on cost and availability, a bank will use a variety of liability management instruments to obtain the liquidity needed for daily cash management, for loan e)pansion, and for other earnings opportunities. !iability management provides a bank with an alternative to asset liquidation to obtain needed funds, and the bank chooses between these alternatives based on the relative costs and risks involved. Bor e)ample. depending on a bank/s si#e and on market conditions, a bank in need of liquidity may chose to borrow government funds or issue 'E/s rather than sell Treasury bills or other liquid assets. !iability management also provides a bank with an alternative to asset management in obtaining the greatest value from inflows of funds. Therefore a bank which follows both assets and liability management strategies has the option of using cash inflows to obtain more short term liquid assets or to repay outstanding liabilities, depending on which option provides the best combination of earnings and safety.

BENEFITS OF LIABILITY MANAGEMENT The key benefit of using !iability "anagement as a funding strategy is that ssume that the bank e)periences a sudden

it provides a bank with an alternative to asset management for short term ad+ustments of funds. Bor e)ample. and une)pected marked decline in the level of its demand deposits. If the bank/s only source of liquidity is its assets, it must sell some of its securities to obtain the funds needed to cover the run off of its deposits, whether or not market conditions are favorable. 4ith liability management, the bank may be able to raise the needed

39

funds by incurring liabilities, thereby postponing the sale of its assets until conditions are more favorable. !iability management also provides a bank with the means of funding long

term growth. It does so by enabling a bank to e)pand its loans ad other assets by managing its liabilities so that a certain volume of its liabilities remains outstanding at all times so that it can build up on its deposit levels and thereby e)pand the level of its loans. This approach of funding is normally followed within a conte)t of a long term upswing in the economy in which the borrowers seek more loans for business e)pansion and depositors place their funds in negotiable time certificates to earn competitive rates. In such cases, bank management must have a clear idea of the level of outstanding liabilities that it can count on holding through tight money periods by offering competitive rates. nother benefit of liability management is that it allows banks to invest

greater percentage of its available funds in its securities that provide less liquidity but offer higher earnings, this is possible because the bank/s liquidity account does not have to bear the full burden of the bank/s liquidity needs. bank that has the option of obtaining liquidity through its liabilities has an opportunity to increase profitability because it can reduce the amount of short term assets it holds for liquidity purposes and place those funds into longer term securities that offer less liquidity but offer higher earnings.

RIS2S IN1OL1ED IN LIABILITY MANAGEMENT lthough the use of liability management along with asset management

allows a bank the least costly method of obtaining liquidity from a wider range of
40

funding options, but the added options that liability management provides also require greater comple)ity in planning and e)ecuting funds management strategies. This is so since banks can obtain money market deposits and liabilities only by paying market rates and the behavior of financial markets cannot be predicted with complete accuracy. nother risk involved is that of issuing long term fi)ed rate 'E/s at the peak of the business cycle. This results in more costly 'E/s in the future with a fall in the interest rates. In fact if short term assets are funded by long term liabilities and rates subsequently decline, a bank may find that it is paying more for funds than it can earn on those funds. nother risk that relates to the changing market conditions is the stability of the bank/s sources of borrowed or purchased funds. 4hile large money center banks are usually able to obtain funds under tight money conditions if they are willing to pay market rates, smaller banks may find it impossible to compete for funds when prices are high. The risk that a funding house may prove unreliable is also a real problem for smaller banks that move outside their trading areas or that undertake funding by means of liability instruments with which they are not completely familiar. %uch banks face the very real possibility that their sources of funds may disappear +ust when they are most needed.

GA" MANAGEMENT
The basic benefits of liability management lie in the options it provides a bank in obtaining a least costly method of funding given the bank/s particular needs and the e)isting conditions of the financial markets. The risk involved in liability management basically results from too much reliance on the use of

41

purchased funds without recogni#ing the impact that changing market conditions or other unanticipated changes can have on the bank/s ability to secure funds when the money is scarce. In a Fap management strategy, the aim is to reduce the volatility of the net interest income. >nlike the aggressive strategy, there is no attempt to profit from the anticipated change in rates. The defensive strategy attempts to keep the volume of rate sensitive assets in balance with that of rate sensitive liabilities over a given period. If successful, an increase in the interest rates will produce equal increases in interest revenue and interest e)pense, with the result that net interest income and net interest margin will not change. It is important to note that a defensive strategy is not necessarily a passive strategy. 'ontinuous ad+ustments to the assets and liability portfolio are necessary to maintain #ero Fap. Bor e)ample, suppose a variable rate loan was paid off. If the Fap were #ero prior to the pay$off, it would be negative afterwards and ad+ustments will have to be made. In order to restore the #ero Fap, the manager would have to add short term securities. The following table shows the effects of interest rate changes on different types of Fap. GA" 6ositive 6ositive 5egative 5egative Gero Gero C anges in Net Inte!est C anges in Ma!*et In,(me 1al#e (+ EB#ity Increase Eecrease Eecrease Increase Increase Increase Eecrease Eecrease Increase Gero Eecrease Eecrease

"ROBLEMS IN GA" MANAGEMENT

42

lthough widely used in practice, Fap, management (whether aggressive or defensive) has a number of drawbacks. The first complication is the selection of the time hori#on. s discussed earlier, the separation of assets and liabilities into rate sensitive and non A rate sensitive requires the establishment of a time hori#on. lthough necessary, the selection of the time hori#on causes problems because it ignores the time at which the interest rate sensitive assets are repriced, implicitly assuming that all rate sensitive assets and liabilities are repriced on the same day. s e)amples of the problem caused by such an assumption, consider a bank which has #ero Faps. Burther assume that the maturity of the rate sensitive assets is one day, that of the rate sensitive liabilities @<days and the time hori#on selected is @<days.given these assumptions, interest rate changes clearly would affect the net interest income of the bank even though it had #ero Fap. 7ne common solution to this problem is to divide assets and liabilities into separate categories referred to as maturity buckets and mange each maturity bucket separately. 4ith the buckets, Fap management becomes management of the different buckets. The Fap for each maturity bucket is referred to as an incremental Fap. The incremental Fap of all the buckets is added to get the total Fap. The second problem with Fap management is the implicit assumption that the correlation coefficient between the movement in general market interest rate and the interest revenue and costs to the bank are constant. In other words, if interest rat rise or fall by one percent, the revenues and interest costs to the bank will also rise or fall by one percent. 7ne method of dealing with the problem imperfect correlation is the use of standardi#ed Fap. This measure of Fap ad+ust for the different interest rate volatilities of various assets and liabilities. It uses the historical relationship between market rates and rates for a bank/s asset and

43

liability items in order to alter the maturity and therefore the sensitivity of the portfolio items. problem related to aggressive Fap management is the need to make interest rate forecasts. 4ith a lot of assumptions, rate forecast are made and based on these a number of decision are made. final problem with the Fap management is its n narrow focus on net interest income as opposed to shareholder wealth.

asset-liability manager may ad+ust portfolio so that the net interest income will rise with changes in interest income but the value of shareholder wealth may decrease. ggressive asset-liability management based on interest rate predictions may increase the risk of loss. If successful, aggressive Fap management may increase net income but add to the volatility of that income.

ALM "RINCI"LES TAS2 FORCE

The Task Borce was comprised of members of the actuarial profession with e)perience in !" in the >nited %tates and 'anada. The !" principles articulated in this document are applicable to a broad range of entities facing !"$related issues. The applicability of these principles will depend on the relevant conte)t and circumstances of each such entity. lthough the principles herein are intended to cover a broad range of topics and issues, there may be other factors not discussed here, and some of the definitions may be interpreted differently based on the conte)t of a particular industry under the consideration. 4henever possible, the document attempts to capture these differences, such as in the case of pension plans and trust funds. 0owever, independent professional +udgment must be e)ercised in all situations. %ince the early work of Brank ". &edington in the 89L<s, actuaries have

44

applied actuarial techniques and skills to !" for insurance companies, pension funds, investment firms, and other financial institutions. To recogni#e this contribution, the %ociety of ctuaries/ Binance 6ractice rea dvancement 'ommittee formed the sset !iability "anagement 6rinciples Task Borce (*Task Borce,), with the charge to identify and articulate the principles of !". The original Task Borce was formed in 899M and distributed an initial draft !" 6rinciples document in 899=. t that time, there e)isted divergent views on the central principle of !" A economic value. Binancial industry practice at the time placed greater importance on accounting results rather than economic value, and this issue was debated at length. "uch has happened since 899=. 3quity analysts and rating agencies began calling for a more meaningful way to value companies than the traditional accounting measures. Internationally, pressure mounted to move to fair value$based accounting standards. ccounting scandals shed new light on how easily accounting earnings could be manipulated and the emergence of earnings distorted. The importance of focusing on economic value was no longer a theoretical argument. revitali#ed Task Borce took up the call to finali#e the !" 6rinciples document in the spring of C<<@ and unanimously recogni#ed economic value as the central principle of !". This document incorporates changes the Task Borce considered appropriate based on the many comments received in response to the original e)posure draft. 4hile specific considerations and methodology used to in implementing !" may differ between insurance companies, private pension plans, public pension plans and social insurance systems, the principles articulated in this document broadly apply to all entities. C#!!ent membe!s (+ t e Tas* F(!,e a!e6

45

'harles !. Filbert, 'hairperson "ark 4. Bursinger 3varonda 'hung 'harles D. Bord Eavid '. Filliland Brederick 4. (ackson 3mily O. Oessler Brank (. !ongo (osephine 3. "arks 'atherine F. &eimer "a) (. &udolph lbert D. %ekac 6eter E. Tilley %7 Binance 6ractice ctuary. Dalentina Isakina They would also like to acknowledge "ichael . 0ughes (6ast 'hairperson), 'indy Borbes, (oseph ". &afson, and (oseph Tan for their contributions to the early work of the task force. This report represents the findings and conclusions of the Task Borce.

ASSET-LIABILITY MANAGEMENT DECISIONS IN "RI1ATE BAN2ING This research discusses the sources of added$value in private wealth management, and argues through a series of illustrations that asset$liability

46

management is the natural approach for the design of truly client$driven services in private banking 4orking from the observation that the contribution of asset$liability management techniques developed for institutional investors is not yet familiar within private banking, this study shows the e)pected benefits of a transposition of that kind. sset$liability management represents a genuine means of adding value to private banking that has not been sufficiently e)plored to date. 4ithin the framework of private financial management offerings, personal wealth managers tend to confine their clients to mandates that are only differentiated through their level of volatility, without the client/s personal wealth constraints and ob+ectives being genuinely taken into account in order to determine the overall strategic asset allocation. In that sense, private wealth management is not sufficiently different from the management of a diversified or profiled mutual fund.

ASSET LIABILITY MANAGEMENT 3ALM4 GUIDELINES FOR REGIONAL RURAL BAN2S 3RRBS4 &egional &ural Banks (&&Bs) are now operating in a fairly deregulated environment and are required to determine their own interest rates on deposits and on their advances which are sub+ect to only the "inimum !ending &ate ("!&) prescription. The interest rates on bank/s investments in government and other permissible securities are also now market related. Intense competition for

47

business, involving both the assets and liabilities, together with increasing volatility in the domestic interest rates and foreign e)change rates, has brought pressure on the management of banks to maintain an optimal balance between spreads, profitability and long$term viability. The unscientific and ad$hoc pricing of deposits in the conte)t of competition, and alternative avenues for the borrowers, results in inefficient deployment of resources. t the same time, imprudent liquidity management can put banks/ earnings and reputation at great risk. These pressures call for a comprehensive approach towards management of banks/ balance sheets and not +ust ad hoc action. The managements of &&Bs have to base their business decisions on sound risk management systems with the ultimate ob+ective of protecting the interest of depositors and stakeholders. It is, therefore, important that &&Bs introduce effective sset$!iability "anagement ( !") systems to address the issues related to liquidity, interest rate and currency risks. s desired by the &BI, the 5 B &E has undertaken the task of framing suitable guidelines on sset$ !iability "anagement ( !") for &&Bs. The !" guidelines devised by the 5 B &E have been sent to &BI for their formal approval and thereafter it would be discussed and e)plained e)tensively in the 4orkshops to be organised by 5 B &E. The drafts !" Fuidelines prepared by 5 B &E are enclosed. %alient features of which are discussed hereunder. &&Bs are required to put in place an effective !" %ystem, as per the enclosed Fuidelines, preferably, by @< (une C<<:. The banks should set up an internal sset$ !iability 'ommittee ( !'7), headed by the 'hairman The Board should oversee the implementation of the system and review its functioning periodically.

48

Oeeping in view the level of computerisation and the current "I% in many of the &&Bs, adoption of a uniform !" %ystem by all banks may not be feasible. The enclosed Fuidelines have been formulated to serve as a benchmark for those banks which lack a formal !" %ystem. Banks which have already adopted more sophisticated systems may continue their e)isting systems, but should ensure to fine$tune their current system to ensure compliance with the requirements of the !" %ystem suggested in the enclosed Fuidelines. 7ther banks should e)amine their e)isting "I% and arrange to have an information system to meet the prescriptions of the !" Fuidelines.

GUIDELINES 'onsidering their structure, balance sheet profile and skill levels of personnel of &&Bs, &BI and 5 B &E found it necessary to provide technical support for putting in place an effective !" framework. These Fuidelines lay down broad framework for measuring liquidity, interest rates and fore) risks. The initial focus of the !" function would be to enforce the risk management discipline vi#. managing business after assessing the risks involved. The ob+ective of good bank management is to provide strategic tools for effective risk management systems. &&Bs need to address the market risk in a systematic manner by adopting necessary sectorA specific !" practices than has been done hitherto. !", among other functions, also provides a dynamic framework for measuring, monitoring and managing liquidity, interest rate and foreign e)change (fore)) risks. It involves assessment of various types of risks and altering balance sheet (assets and liabilities) items in a dynamic manner to manage risks.

49

ASSET-LIABILITY MANAGEMENT IN COMMERCIAL BAN2S 3ver since the initiation of the process of deregulation of the Indian banking system and gradual freeing of interest rates to market forces, and consequent in+ection of a dose of competition among the banks, introduction of asset$liability management ( !") in the public sector banks (6%Bs) has been suggested by several e)perts. But, initiatives in this respect on the part of most bank managements have been absent. This seems to have led the &eserve Bank of India to announce in its monetary and credit policy of 7ctober 899: that it would issue !" guidelines to banks. 4hile the guidelines are awaited, an informal check with several 6%Bs shows that none of these banks has moved decisively to date to introduce !". 7ne reason for this neglect appears to be a wrong notion among bankers that their banks already practice !". s per this understanding, !" is a system of matching cash inflows and outflows, and thus of liquidity management. 0ence, if a bank meets its cash reserve ratio and statutory liquidity ratio stipulations regularly without undue and frequent resort to purchased funds, it can be said to have a satisfactory system of managing liquidity risks, and, hence, of !". The actual concept of !" is however much wider, and of greater importance to banks; performance. 0istorically, !" has evolved from the early practice of managing liquidity on the bank;s asset side, to a later shift to the liability side, termed liability management, to a still later realisation of using both the assets as well as liabilities sides of the balance sheet to achieve optimum resources management. But that was till the 89:<s. In the 89=<s, volatility of interest rates in >% and 3urope caused the focus to broaden to include the issue of interest rate risk. !" began to e)tend beyond the bank treasury to cover the loan and deposit

50

functions. The induction of credit risk into the issue of determining adequacy of bank capital further enlarged the scope of !" in later 89=<s. In the current decade, earning a proper return of bank equity and hence ma)imisation of its market value has meant that !" covers the management of the entire balance sheet of a bank. This implies that the bank managements are now e)pected to target required profit levels and ensure minimisation of risks to acceptable levels to retain the interest of investors in their banks. This also implies that costing and pricing policies have become of paramount importance in banks. In the regulated banking environment in India prior to the 899<s, the equation of !" to liquidity management by bankers could be understood. There was no interest rate risk as the interest rates were regulated and prescribed by the &BI. %preads between the deposit and lending rates were very wide (these still are considerable)1 also, these spreads were more or less uniform among the commercial banks and were changed only by &BI. If a bank suffered significant losses in managing its banking assets, the same were absorbed by the comfortably wide spreads. 'learly, the bank balancesheet was not being managed by banks themselves1 it was being ?managed; through prescriptions of the regulatory authority and the government. This situation has now changed. The banks have been given a large amount of freedom to manage their balance sheets. But the knowledge, new systems and organisational changes that are called for to manage it, particularly the new banking risks, are still lagging. The turmoil in domestic and international markets during the last few months and impending changes in the country;s financial system are a grim warning to our bank managements to gear up their balance sheet management in a single heave. To begin with, as the &BI;s monetary and credit policy of 7ctober 899: recommends, an adequate system of !" to incorporate comprehensive risk management should be introduced in the

51

6%Bs. It is suggested that the 6%Bs should introduce !" which would focus on liquidity management, interest rate risk management and spread management. Broadly, there are @ requirements to implement !" in these banks, in the stated order. (a) developing a better understanding of !" concepts, (b) introducing an !" information system, and, (c) setting up !" decision$making processes ( !" 'ommittee- !'7). The above requirements are already met by the new private sector banks, for e)ample. These banks have their balance sheets available at the close of every day. &epeated changes in interest rates by them during the last @ months to manage interest rate risk and their maturity mismatches are based on data provided by their "I%. In contrast, loan and deposit pricing by 6%Bs is based partly on hunches, partly on estimates of internal macro data, and partly on their competitors; rates. 0ence, 6%Bs would first and foremost need to focus son putting in place an !" which would provide the necessary framework to define, measure, monitor, modify and manage interest rate risk. This is the need of the hour.

ROLE OF RESER1E BAN2 OF INDIA

The &BI, through its credit policy announcements, various directives and guidelines on !", has spelt out the need for having a comprehensive risk management policy. The &BI, in its monetary and credit policy and subsequent guidelines issued in Bebruary 8999, recommended that an adequate system of !" be put in place. The &BI had advised banks in Bebruary, 8999 to put in place an !" system, effective pril 8, 8999 and set up internal sset$!iability "anagement 'ommittee at the top management level to oversee its implementation. Banks were e)pected to cover at least M< percent of their liabilities and assets in the interim and 8<< percent of their business by &BI has also released pril 8, C<<<. The !" system guidelines in (anuary, C<<< for all India term$
52

lending and refinancing institutions. Burther, it even suggested that financial institutions should introduce !", which would primarily focus on liquidity management and interest rate risk management. 0aving, thus, laid these requirements to implement !", in the stated order. ( ) Eeveloping a better understanding of !" concepts (B) Introducing an !" information system (') %etting up !" decision A making process ( !" committee - !'7), it is for the institutions to act and implement the same.

CONCLUSION
3mergence of new players, new instruments and new products at competitive rates in the market following the reform process in India further increased the bank/s risk. These developments faced the commercial banks to take a re$look on the assets and liabilities management to remain competitive and withstand the risk associated with management of asset and liability. The &BI vide its circular dated Bebruary 8C, 899=, advised commercial banks to tighten their asset$liability management and put in place an appropriate system of asset$liability management. The &BI has decided to test a model on the few lending banks whereby banks have been asked to furnish data in a format out$lined by it. Increasingly banks and asset management companies started to focus on sset$!iability &isk. The problem was not that the value of assets might fall or that the value of liabilities might rise. It was that capital might be depleted by narrowing of the difference between assets and liabilities and that the values of assets and liabilities might fail to move in tandem. sset$liability risk is predominantly a leveraged form of risk.

53

The capital of most financial institutions is small relative to the firm;s assets or liabilities, and so small percentage changes in assets or liabilities can translate into large percentage changes in capital. ccrual accounting could disguise the problem by deferring losses into the future, but it could not solve the problem. Birms responded by forming asset$liability management ( !") departments to assess these asset$liability risk.

54