ASSETS/LIABILITY Management Committee

(ALCO)
INTRODUCTION

Asset Liability Management (ALM) acts like a backbone

of any Bank or financial institution, which arises the
need to design a systematical and well-structured
policy to manage the balance sheet.
To design said policy all banks have a committee
typically called ALCO, comprising of senior
management who are responsible of making
important decisions related to Balance sheet of the
bank.

This senior management committee (ALCO) is

responsible for making policies on asset-liability and
risk management. No of members in committee varies
in each Bank and meetings are held at least one
meeting in a month where board members make
policy for asset-liability miss matches, use of balance
sheet, liquidity, interest rates so forth.

OBJECTIVES

• Day to day management of balance sheet it helps

in achieving short-term goals.

• Annual profit planning which generally helps in

achieving slightly long term goals, detailed
financial planning of a fiscal year.

• Strategic planning of long run financial and non

financial operations of Bank.

FUNCTIONS of ALCO

• Liquidity risk management

 • Management of market risks (including Interest
Rate Risk)

• Funding and capital planning

• Profit planning and growth projection

• Trading risk.

CREDIT RISK MANAGEMENT

It plays a big role in the performance of a bank and it

reflects on the following things:

The profitability

Liquidity

Reduced NPAs

Credit risk management is a process which is put on

place to identify the risk of the bank and
measurement in order to reduce the risk which can
affect the bank performance, business strategy and
exposure on bank statement.

WAY FOR CREDIT RISK MANAGEMENT

Credit risk management is based on two levels Micro

and Macro. Micro level mainly focuses on client’s
performance of the operating staff in credit
evaluation.

In macro level, Capital adequacy Ratio plays an

important role. The industry exposure is stipulated by
the bank management so they can keep the overall
status of its credit deployment.
There is a lot of risk in credit assets and every asset is
required to make specific returns. If you do not make
the certain assets returns which is expected is a
default risk which is associated with credit assets.
There is another way of managing the credit risk is the
use of credit derivatives. It facilitates risk transfer and
the idea has been picked up in Europe and USA but it’s
still to be picked up in India due to pathetic scenario of
loan portfolio.

(Sinkey, J.F. (1992))

MEASURING INTEREST RATE SENSITIVITY

Gap analysis is the mostly used method of the interest

position of a bank. The Gap is difference between the
amount of the rate sensitive assets and rate sensitive
liabilities. It can be described in different ways, the
simple one is rupee Gap. So the different between rate
sensitive assets and rate sensitive liabilities are
expressed in rupees. Other methods of gap are Gap
ratio which is the ratio of the rupee gap and total
assets.

Relative Gap ratio = Rupee Gap / Total assets

Interest rate sensitivity ratio = RSA / RSL

A bank can be asset or liability sensitive at times. If

the bank is in asset sensitive it shows the positive Gap
and appositive gap ratio and interest sensitivity ratio
would be greater than one. If a bank is liability
sensitive it shows a negative Gap. It means Gap ratio
and interest sensitivity ratio will be less than one. So
banks who are asset sensitive would increase their net
interest income when the interest rate increase but
other hand banks who are liability sensitive would
decrease their net income.

Gap Changes in Changes in Net Interest

Interest Rate Rate
Positive Increase Increase
Positive Decrease Decrease
Negative Increase Decrease
Negative Decrease Increase
Zero Increase Zero
Zero Decrease Zero

The main focus of asset/liability management is on

interest rate risk although management is also
concerned to manage the whole risk profile of that
institutions which includes interest risk, liquidity risk,
credit risk and other risks. If other risks are not related
then managers can concentrate on one kind of risk.
Some types of risks have a high degree of correlation
like the credit risk and interest risk.

(Sinkey, J.F. (1992))

Liquidity Risk Management

It’s a vital for commercial banks to measure and

manage liquidity needs. To ensure that they can meet
its liabilities and they got the ability to meet their
liabilities when they are outstanding and the adverse
situation development can be reduced by liquidity
management. If there is a liquidity shortfall in any
institution it can have an indirect affect on the entire
system. Bank management should not only focus on
liquidity position of banks, they also need to examine
that how liquidity requirements are evolved under
crisis. The future cash flows of banks can be measured
by maturity profile in different time buckets which are
followed:

• 1 > 14 days

• 15 > 28 days

• 29 > up to 90 days

• Over 90 > up to 180 days

• Over 180 > up to 365 days

• Over 365 > up to 730 days

• Over 730 > up to 1825 days

• Over 1825 days

N.S. Toor( Dec. 2006 )

LIQUIDITY MANAGEMENT IN FINANCIAL INSTITUTIONS

Strong capital is not a guarantee of liquidity in all

situations and circumstance because of panic and
sudden increase in the demand for liquidity. To
understand better how Authorities view liquidity
concerns and how they meet the requirements of
different institutions, Reserve Bank of India Governor
states, “liquidity management is carried out through
Open Market Operation (OMO) in the form of out right
purchase / sales of government securities and reverse
repo / repo operations, supplemented by the newly
introduced Market Stabilization Schemes(MSS). The
Liquidity Adjustment Facility (LAF), introduced in June
2000, enables the RBI to modulate short term
liquidity, of a temporary nature, under varied financial
market conditions in order to ensure stable conditions
in the overnight (call) money market”. RBI financial
institution implements various tools such as:

N.S. Toor( Dec. 2006 )

Liquidity Assets:

There are different authorities in different parts of the

world who have prescribed financial institutions to
keep certain percentage of liquid assets to their
liabilities. For Example, central bank of Solomon
Islands requires financial institution to keep minimum
liquid assets of 7% of their liabilities. Similarly RBI
states, it could vary with requirements of the
institution.

Limit on Maturity Mismatches

The gaps between maturing assets and liabilities in

different time buckets can be monitored and
controlled by financial institutions. The maturity profile
should take into consideration of its cash flows and
balance sheet exposure. It relies heavily on
assumptions that certain amount of maturity liabilities
will be able to rollover. Various authorities have
prescribed that this aspect can be monitored by limits
and control measures.

N.S. Toor( Dec. 2006 )

Diversified Source for Liability Raising

A well diversifies funding should be maintained by the

institutions and also understand that constantly
approaching markets like borrowing funds can be
costly affair. This kind of practice has been cautioned
by regulatory authorities.

Funds from the Wholesale Markets

Its an important source of liquidity where funds can be

generated in the interbank market or other whole sale
markets but this can be reduced and delayed in crisis
situations

Boards approved Contingency Plan

A well organized plan which is approved by the boards

can include in order dealing with the major liquidity
problems.

Currency Risk management

There is a risk in dealing with different currencies

because if the liabilities exceed the level of assets in
one currency then the currency mismatch can add
value/ erode value which depends on the movements
of that currency. If its gone to zero or close to zero,
banks normally operate in foreign exchange for
example deposits, loans, advances and quoting prices
for transaction of foreign exchange.

There is another dimension of Asset Liability

Management which operating/managing the currency
risk. These days banks can set up gap limits with the
approval of RBI they are required to adopt the Value
At Risk approach in order to measure the risk which is
associated with forward exposures.

N.S. Toor( Dec. 2006 )

STRATEGIES FOR ASSET / LIQUIDITY MANAGEMENT

The main purpose of asset/liability management is to

control the size of net interest income which can be
aggressive and defensive. The defensive asset/liability
management focuses on net interest income from
changes in interest rates. On the other hand
aggressive assets/liability concentrates on increasing
the net interest income by altering the portfolio of that
institution. Its an important for the success of
aggressive asset/liability management is to predict the
future interest rate changes. In defensive asset/
liability its not necessary to forecast the future
interest rate changes.

(Sinkey, J.F. (1992).)

USING FUTURES, SWAPS AND OPTIONS

Banks use new techniques to manage to asset/liability
portfolio although these instruments have come into
consideration two decades ago in US and Europe.
Europe have made tremendous success in
asset/liability management.

Interest rate swap is one the major technique which is

used to manage interest rate risk. In this technique
two companies want to change their interest rate
exposure in different direction through an
intermediary in order to pay interest. They only swap
their interest not their principal.

It has their advantages and disadvantages. First they

just meet the needs of the banks and secondly it can
be arranged for long period of time. Future contracts
usually for short period of time. It has its
disadvantages which is called customized contracts
which take time to get the things right and its also
difficult to make a swap and close out a contract
compare to future contracts.

(Sinkey, J.F. (1992).)

AGGRESSIVE GAP MANAGEMENT

Management can control the interest rate risk of it

portfolio by focusing on the Gap. This kind of
technique tends to make the profit from the
interest rate movements. First they have to
forecast the future interest rate and then they
have to make adjustments on the interest
sensitivity of the assets/liabilities so advantage
can be taken from the projected changes in rates.
Normally if the predicated interest rates is raising
it shows a positive Gap but if it goes down it shows
the negative Gap.

DEFENSIVE GAP MANAGEMENT

In this strategy, the aim is to reduce the volatility of

the interest rate income. There is no struggle to make
the profit from the forecast changes in rate. It
normally keeps the volume of rate sensitive assets in
balance with the rate sensitive liabilities over a certain
period of time. If the interest rates increase will give
equal increases in interest expenses and revenue so in
that case net interest income and net interest margin
will not change.

DURATION GAP MANAGEMENT

Gap management basically focus on the

accounting income instead concentrating on the
market value of the equity, to search for
alternative method for asset/liability management
is called Duration Gap Management. Duration
analysis mainly focuses on the market value of
that bank where market value holds the value of
current income and future income. With these
analyses they can estimate the effects of
fluctuating interest rates on the market value of
the assets/liabilities. Once duration are computed,
the effects of changing interest rates can be
measured by taking the sum of changes and put
them in the market value of assets and liabilities.
 Gap Changes in Changes in Net Interest
Interest Rate Rate
Positive Increase Increase
Positive Decrease Decrease
Negative Increase Decrease
Negative Decrease Increase
Zero Increase Zero
Zero Decrease Zero

CONCLUSION
As we have discussed in details the function and
objectives of asset and liability which is performed by the
committee which controls the interest, gap management risk
management, credit risk management and annual profitability
which can underline the performance of any organization. There
are different methods where you can forecast the interest income
of an organization by using gap management methods. ALCO
also plans the strategies of asset/liability management. So it has
an important affect on any organization’s performance, its
interest income and mismatch of its assets and liabilities.

BIBLIOGRAPHY

BOOKS :

Sinkey, J.F. (1992). Commercial bank financial

management(4th ed). New York: Maxwell Macmillan
International Edition.

N.S. Toor( Dec. 2006 ) Hand Book of Banking Information,

SKYLARK Publications, 1.08 l

Managing Indian Banks, The Challenges Ahead, 2nd Edition,

Sage publication, Author – Vasant C. Joshi & Vinay V. Joshi,
chapter 11, Asset/liability management Pg No. 226 to 238
MAGAZINES:

E. N. Murthy, “Managing assets and liabilities”, ICFAI journal

Professional Banker(March 2008) Pg No. 11 to 13

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