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SRI SHARDA INSTITUTE OF INDIAN MANAGEMENT –

RESEARCH

PROJECT ON “ASSET LIABILITY


MANAGEMENT”

SUBMITTED TO SUBMITTED BY
PROF ; SANJEEV PARMAR KARISHMA
GUPTA
PGDM (2009-2011)
ROLL NO 20090127
ACKNOWLEDGEMENT
A Project Report is never successfully completed without the guidance from appropriate
person. So, Now it is the right time to express my sincere gratitude towards all those, who
have helped me to complete the project.

I would like to thank SWAMI (Dr.) Parthasarathy CMD, Sri Sharda Institute of Indian
Managament - Research who has given me the opportunity to study in such Unique
Institute. I am very much grateful to Mr. Sanjeev Parmar for his expert guidance and for
his moral support and encouragement which lead the project to its current shape Without
their Guidance the work would never been completed.

Last but not the least I would like to appreciate my parents who have always motivated
me directly and indirectly to do my work with utmost Dedication.
INTRODUCTION

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. It takes into consideration interest rates, earning power, and degree of
willingness to take on debt and hence is also known as Surplus Management.

But in the last decade the meaning of ALM has evolved. It is now used in many different
ways under different contexts. ALM, which was actually pioneered by financial
institutions and banks, are now widely being used in industries too. The Society of
Actuaries Task Force on ALM Principles, Canada, offers the following definition for
ALM: "Asset Liability Management is the on-going process of formulating,
implementing, monitoring, and revising strategies related to assets and liabilities in an
attempt to achieve financial objectives for a given set of risk tolerances and constraints."

Traditionally, banks and insurance companies used accrual system of accounting for all
their assets and liabilities. They would take on liabilities - such as deposits, life insurance
policies or annuities. They would then invest the proceeds from these liabilities in assets
such as loans, bonds or real estate. All these assets and liabilities were held at book value.
Doing so disguised possible risks arising from how the assets and liabilities were
structured.

Before go further in detailed let’s first understand the basic terms of asset liability
management such as asset, liability, asset management, liability management etc

What Does Asset Mean?


A resource with economic value that an individual, corporation or country owns
An asset is a balance sheet item representing what a firm owns controls with the
expectation that it will provide future benefit.

Components of Assets
1. Cash & Bank Balances with RBI

I. Cash in hand

(including foreign currency notes)

II. Balances with Reserve Bank of India


a) In Current Accounts

b) In Other Accounts

2. Balances With Banks And Money At Call & Short Notice

I. In India

i) Balances with Banks

a) In Current Accounts

b) In Other Deposit Accounts

ii) Money at Call and Short Notice

a) With Banks

b) With Other Institutions

II. Outside India

a) In Current Accounts

b) In Other Deposit Accounts

c) Money at Call & Short Notice

3. Investments

A major asset item in the bank’s balance sheet. Reflected under 6 buckets as
under:

I. Investments in India

i) Government Securities

ii) Other approved Securities

iii) Shares

iv) Debentures and Bonds

v) Subsidiaries and Sponsored Institutions


vi) Others (UTI Shares , Commercial Papers, COD &

Mutual Fund Units etc.)

II. Investments outside India in **

Subsidiaries and/or Associates abroad

4. Advances

The most important assets for a bank.

A. i) Bills Purchased and Discounted

ii) Cash Credits, Overdrafts & Loans

repayable on demand

iii) Term Loans

B. Particulars of Advances :

i) Secured by tangible assets

(including advances against Book Debts)

ii) Covered by Bank/ Government Guarantees

iii) Unsecured

5. Fixed Asset

I. Premises

II. Other Fixed Assets (Including furniture and fixtures)

6. Other Assets

I. Interest accrued

II. Tax paid in advance/tax deducted at source

(Net of Provisions)
III. Stationery and Stamps

IV. Non-banking assets acquired in satisfaction of claims

V. Deferred Tax Asset (Net)

VI. Others

What Does Liability Mean?


• A company's legal debts or obligations that arise during the course of business
operations. Liabilities are settled over time through the transfer of economic
benefits including money, goods or services.

Components of Liabilities
1. Capital:

Capital represents owner’s 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

Components under this head includes:

I. Statutory Reserves

II. Capital Reserves

III. Investment Fluctuation Reserve

IV. Revenue and Other Reserves

V. Balance in Profit and Loss Account

3. Deposits

This is the main source of bank’s funds. The deposits are classified as deposits
payable on ‘demand’ and ‘time’. They are reflected in balance sheet as under:

I. Demand Deposits
II. Savings Bank Deposits

III. Term Deposits

4. Borrowings

(Borrowings include Refinance / Borrowings from RBI, Inter-bank & other


institutions)

I. Borrowings in India

i) Reserve Bank of India

ii) Other Banks

iii) Other Institutions & Agencies

II. Borrowings outside India

5. Other Liabilities & Provisions

It is grouped as under:

I. Bills Payable

II. Inter Office Adjustments (Net)

III. Interest Accrued

IV. Unsecured Redeemable Bonds

(Subordinated Debt for Tier-II Capital)

V. Others(including provisions)
Liability Management
• Liability management is the coordination and control of all of a bank’s sources of
funds in order to maintain liquidity, profitability and safety to support long term
growth It is the purchase and sale of funds to make short term liquidity
adjustments.

• 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 obtain

• Liability management seeks to control the sources of funds that a bank can obtain
quickly and in large amounts(money market deposits and liabilities), unlike
demand and savings deposits, which cannot be increased to any great degree over
a short time period.

Benefits of Liability Management

• Alterative to asset management


• It provides bank with means of funding long term growth
• It allows bank to invest a greater percentage of its available funds in securities
that provide less liquidity but offer higher earnings

Asset Management
• Liquidity in asset portfolio is maintained by structuring assets so that fluctuations
in deposit levels can be covered and demands for credit can be met by holding
liquid assets that will be sold or that will mature to meet liquidity needs.

• Thus, asset management is concerned with adjustments in the price and


availability of credit and in the banks holding of liquid assets in relation to deposit
and loan patterns.
Assets Liability Management
It is a dynamic process of Planning, Organizing & Controlling of Assets &
Liabilities- their volumes, mixes, maturities, yields and costs in order to maintain
liquidity and NII.

• 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. It takes into consideration interest rates,
earning power, and degree of willingness to take on debt and hence is also known
as Surplus Management.

• Asset Liability Management is the on-going process of formulating,


implementing, monitoring, and revising strategies related to assets and liabilities
in an attempt to achieve financial objectives for a given set of risk tolerances and
constraints."

• A-L management is coordinating the banks portfolios of assets and liabilities in


order to maximise bank profitability and stockholders earnings over the long term,
consistent with safety and liquidity needs

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

• Banks manage the risks of Asset liability mismatch by matching the assets and
liabilities according to the maturity pattern or the matching the duration, by
hedging and by securitization.

• Increasingly banks and asset management companies started to focus on Asset-


Liability Risk. 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. Asset-liability risk is predominantly a
leveraged form of risk.
• 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. Accrual accounting could disguise the
problem by deferring losses into the future, but it could not solve the problem.
Firms responded by forming asset-liability management (ALM) departments to
assess these asset-liability risk.

EXAMPLE OF ASSET LIABILITY MANAGEMENT


Consider a bank that borrows 1 Crore (100 Lakhs) at 6 % for a year and lends the same
money at 7 % to a highly rated borrower for 5 years. The net transaction appears
profitable-the bank is earning a 100 basis point spread - but it entails considerable risk. At
the end of a year, the bank will have to find new financing for the loan, which will have 4
more years before it matures. If interest rates have risen, the bank may have to pay a
higher rate of interest on the new financing than the fixed 7 % it is earning on its loan.

Suppose, at the end of a year, an applicable 4-year interest rate is 8 %. The bank is in
serious trouble. It is going to earn 7 % on its loan but would have to pay 8 % on its
financing. Accrual accounting does not recognize this problem. Based upon accrual
accounting, the bank would earn Rs 100,000 in the first year although in the preceding
years it is going to incur a loss.

The problem in this example was caused by a mismatch between assets and liabilities.
Prior to the 1970's, such mismatches tended not to be a significant problem. Interest rates
in developed countries experienced only modest fluctuations, so losses due to asset-
liability mismatches were small or trivial. Many firms intentionally mismatched their
balance sheets and as yield curves were generally upward sloping, banks could earn a
spread by borrowing short and lending long.

ANOTHER EXAMPLE
One example, which drew attention, was that of US mutual life insurance company "The
Equitable." During the early 1980s, as the USD yield curve was inverted with short-term
interest rates sky rocketing, the company sold a number of long-term Guaranteed Interest
Contracts (GICs) guaranteeing rates of around 16% for periods up to 10 years. Equitable
then invested the assets short-term to earn the high interest rates guaranteed on the
contracts. But short-term interest rates soon came down. When the Equitable had to
reinvest, it couldn't get even close to the interest rates it was paying on the GICs. The
firm was crippled. Eventually, it had to demutualize and was acquired by the Axa Group.
Increasingly banks and asset management companies started to focus on Asset-Liability
Risk. 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. Asset-liability risk is predominantly a leveraged form of risk.

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. Accrual accounting could disguise the problem by deferring losses
into the future, but it could not solve the problem. Firms responded by forming asset-
liability management (ALM) departments to assess these asset-liability risk.

OVERALL VEIW
So, basically 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. Asset Liability management (ALM) 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 Asset liability mismatch by matching the assets and liabilities
according to the maturity pattern or the matching the duration, by hedging and by
securitization. Much of the techniques for hedging stem from the delta hedging concepts
introduced in the Black-Scholes model and in the work of Robert C. Merton and Robert
A. Jarrow. The early origins of asset and liability management date to the high interest
rate periods of 1975-6 and the late 1970s and early 1980s in the United States. Van
Deventer, Imai and Mesler (2004), chapter 2, outline this history in detail.

Modern risk management now takes place from an integrated approach to enterprise risk
management that reflects the fact that interest rate risk, credit risk, market risk, and
liquidity risk are all interrelated. The Jarrow-Turnbull model is an example of a risk
management methodology that integrates default and random interest rates. The earliest
work in this regard was done by Robert C. Merton. Increasing integrated risk
management is done on a full mark to market basis rather than the accounting basis that
was at the heart of the first interest rate sensivity gap and duration calculations.
Purpose & Objective of ALM
• An effective Asset Liability Management Technique aims to manage the volume
mix, maturity, rate sensitivity, quality and liquidity of assets and liabilities as a
whole so as to attain a predetermined acceptable risk/reward ratio.
• It is aimed to stabilize short-term profits, long-term earnings and long-term
substance of the bank.
• Planning to meet liquidity needs
• Planning the maturities of assets and liabilities to limit their exposure to interest
rate risk
• A-L Management focuses on maintaining liquidity with maximising profitability
and minimising risks.

As for A-L Management there is a committee formed ie ALCO

ASSET LIABILITY MANAGEMENT COMMITTEE

Asset-Liability Committee - ALCO


• What Does Asset-Liability Committee - ALCO Mean?
A risk-management committee in a bank or other lending institution that generally
comprises the senior-management levels of the institution. The ALCO's primary
goal is to evaluate, monitor and approve practices relating to risk due to
imbalances in the capital structure.

The ALCO Committee consiting of the bank’s senor 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 assets an liability sides) in line with
the bank’s budget and deciding risk management objectives

The ALM desk consisting of operating staff should be responsible for analyzing,
monitering and reporting the risk profiles to the ALCO. The staff should also prepare
forecasts showing the effect of various possible changes in market conditions related to
the balance sheet and recommend the action needed to adhere to banks’s internal limits
STRATEGY OF A-L MANAGENMENT
The main strategy of asset liability management is to do Gap Management

Gap analysis is a technique of ASSET-LIABILITY MANAGEMENT that can be used


to assess interest rate risk or liqidity risk.

Gap analysis was widely adopted by financial institutions during the 1980s. When used to
manage interest rate risk When used to manage interest rate risk, it was used in tandem
with duration analysis. Both techniques have their own strengths and weaknesses.

Duration is appealing because it summarizes, with a single number, exposure to parallel


shifts in the term structure of interest rates. It does not address exposure to other term
structure movements, such as tilts or bends. Gap analysis is more cumbersome and less
widely applicable, but it assesses exposure to a greater variety of term structure
movements.

The use of gap analysis for assessing interest rate risk. It can also be used to assess
liquidity risk. Cash flows are bucketed as above. The only difference is that cash flows
from floaters are bucketed according to their maturity. The actual values of floating rate
cash flows will not be known, but estimated values may be used. The idea of liquidity
gap analysis is to anticipate periods when a portfolio will have large cash out-flows. Such
buckets are called liquidity gaps.

A shortcoming of gap analysis both interest rate and liquidity gap analysis—is the fact
that it does not identify mismatches within buckets. An even more significant
shortcoming is the fact that it cannot handle options in a meaningful way. In today's
markets, options proliferate. Fixed income portfolios routinely hold caps, floors,
swaptions, mortgage-backed securities, callable bonds, etc. Options have cash flows
whose magnitudes—and sometimes timing—is highly uncertain. Those uncertain cash
flows cannot be bucketed. For this reason, gap analysis has largely fallen out of use.
Today, gap analysis is most useful as a theoretical tool for communicating issues related
to interest rate and liquidity risk.
Interest Rate Risk

• Interest rate risk refers to volatility in Net Interest Income (NII) or variations in
Net Interest Margin(NIM).
• Therefore, an effective risk management process that maintains interest rate risk
within prudent levels is essential to safety and soundness of the bank.

Sources of Interest Rate Risk

• Interest rate risk mainly arises from:


– Gap Risk
– Basis Risk
– Net Interest Position Risk
– Embedded Option Risk
– Yield Curve Risk
– Price Risk
– Reinvestment Risk

Measurement of Interest Rate Risk

• Gap Analysis- Simple maturity/re-pricing Schedules can be used to generate


simple indicators of interest rate risk sensitivity of both earnings and economic
value to changing interest rates.

- If a negative gap occurs (RSA<RSL) in given time band, an increase in market


interest rates could cause a decline in NII.

- conversely, a positive gap (RSA>RSL) in a given time band, an decrease in


market interest rates could cause a decline in NII.

• Duration Analysis: Duration is a measure of the percentage change in the


economic value of a position that occur given a small change in level of interest
rate.
Interest Rate Risk Management
• Interest Rate risk is the exposure of a bank’s financial conditions to adverse
movements of interest rates.
• Though this is normal part of banking business, excessive interest rate risk can
pose a significant threat to a bank’s earnings and capital base.
• Changes in interest rates also affect the underlying value of the bank’s assets,
liabilities and off-balance-sheet item.

Liquidity Management
Bank’s 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.

Adequacy of liquidity position for a bank

Analysis of following factors throw light on a bank’s adequacy of


liquidity position:

a. Historical Funding requirement

b. Current liquidity position

c. Anticipated future funding needs

d. Sources of funds

e. Options for reducing funding needs

f. Present and anticipated asset quality

g. Present and future earning capacity and

h. Present and planned capital position

Funding Avenues

To satisfy funding needs, a bank must perform one or a combination of the following:

a. Dispose off liquid assets

b. Increase short term borrowings


c. Decrease holding of less liquid assets

d. Increase liability of a term nature

e. Increase Capital funds

Types of Liquidity Risk


• Liquidity Exposure can stem from both internally and externally.
• External liquidity risks can be geographic, systemic or instrument specific.
• Internal liquidity risk relates largely to perceptions of an institution in its various
markets: local, regional, national or international

Other categories of liquidity risk


• Funding Risk

Need to replace net outflows due to unanticipated withdrawals/non-


renewal

• Time Risk

Need to compensate for non-receipt of expected inflows of funds

• Call Risk

Crystallization of contingent liability

STRATEGIES FOR MISMATCH


• 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 crore over 5 years maturities and
invest it in securities of 1-29 days of Rs 200 crores and rest matching with other
out flows.
CONCLUSION
Asset Liability Management is the on-going process of formulating, implementing,
monitoring, and revising strategies related to assets and liabilities in an attempt to
achieve financial objectives for a given set of risk tolerances and constraints."

It aims to manage the volume, mix, maturity, rate sensitivity, quality and
liquidity of assets and liabilities as a whole so as to attain a predetermined acceptable
risk/reward ration.and also aimed to stabilize short-term profits, long-term earnings
and long-term substance of the bank.

So basically it focuses into maximizing profits and minimizing risk of an


company