ALM IN FOREIGN BANKS

Introduction
Asset Liability Management (ALM) defines management of all assets and liabilities (both off and on balance sheet items) of a bank. It requires assessment of various types of risks and altering the asset liability portfolio to manage risk. Till the early 1990s, the RBI did the real banking business and commercial banks were mere executors of what RBI decided. But now, BIS is standardizing the practices of banks across the globe and India is part of this process. The success of ALM, Risk Management and Basel Accord introduced by BIS depends on the efficiency of the management of assets and liabilities. Hence these days without proper management of assets and liabilities, the survival is at stake. A banks liabilities include deposits, borrowings and capital. On the other side pf the balance sheets are assets which are loans of various types which banks make to the customer for various purposes. To view the two sides of banks balance sheet as completely integrated units has an intuitive appeal. But the nature, profitability and risk of constituents of both sides should be similar. The structure of banks balance sheet has direct implications on profitability of banks especially in terms of Net Interest Margin (NIM). So it is absolute necessary to maintain compatible asset-liability structure to maintain liquidity, improve profitability and manage risk under acceptable limits.

ALM Module
Analytical models are very important for ALM analysis and scientific decision making. The basic models are: 1. GAP Analysis Model 2. Duration GAP Analysis Model 3. Scenario Analysis Model 4. Value at Risk (VaR) model 5. Stochastic Programming Model Any of these models is being used by banks through their Asset Liability Management Committee (ALCO). The Executive Director and other vital departments heads head ALCO in banks. There are minimum four members and maximum eight members. It is responsible for Responsible for Setting business policies and strategies, Pricing assets and liabilities, Measuring risk, Periodic review, Discussing new products and Reporting.

ALM IN FOREIGN BANKS

Asset-Liability Management in Risk Framework

ALM has evolved since the early 1980s. Since then the techniques of ALM have also evolved and the scope of ALM activities has widened. Today, ALM department are addressing foreign exchange risks as well as other risks. Also, ALM has extended to nonfinancial firms. Corporations have adopted techniques of ALM to address interest-rate exposures, liquidity risks and foreign exchange risks. Asset Liability Management will continue to grow further in future and will go a long way in managing volumes, mix, maturity, rate sensitivity, quality and liquidity of the assets and liabilities so as to earn a sufficient and acceptable return on the portfolio. Asset-Liability Management can be termed as a risk management technique designed to earn an adequate return while maintaining a comfortable surplus of asset 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 institution and banks, are now widely being used in industries too. The Society of Actuaries Task Force on ALM Principles, Canada offers the following definition of ALM Asset Liability Management is the on-going process of formulating, implementing, monitoring and revising related to assets and liabilities in an attempt to achieve financial objective for a given set of risk tolerance and constraints.

Basis of Asset-Liability Management

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 annumes. 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 liability were structured. Consider a bank that borrow 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

ALM IN FOREIGN BANKS The end of the 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 year, an applicable 4 years 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 1970s, such mismatches tended not to be a significant problem. Interest rates in developed countries experienced only modest fluctuation, so losses due to assetliability 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. Things started to change in the 1970s, which ushered in a period of volatile interest rates that continued till the early 1980s. US regulation which had capped the interest rates so that banks could pay depositor, was abandoned which led to a migration of dollar deposit overseas. Managers of many firms, who were accustomed to thinking in terms of accrual accounting, were slow to recognize this emerging risk. Some suffered staggering losses. Because the firm used accrual accounting, it resulted in more of crippled balances sheets then bankruptcies. Firms had no options but to accrue the losses over a subsequent period of 5 to 10 years. Increasingly banks and asst management companies started to focus on Asset-Liability Risk. The problem was not that the valve of asset might fall or that the valve of liabilities will rise.It was that the 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 randem. Asset-liability risk is predominantly a leveraged form of risk. The capital of most financial institution is small relative to the firms 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

ALM IN FOREIGN BANKS into the future, but it could not solve the problem. Firms responded by forming assetliability management department to assess these asset-liability risks.

Techniques for Assessing Asset-Liability Risk

Techniques for assessing asset-liability risk came to include Gap Analysis and Duration Analysis. These facilitated techniques of managing gaps and matching duration of asset and liabilities. Both approaches worked well if assets and liabilities comprised fixed cash flows. But cases of callable debts, home loans and mortgages which included option of prepayment and floating rates, posed problems that gap analysis could not address. Duration analysis could address these in theory, but implementing sufficiently sophisticated duration measures was problematic. Accordingly, banks and insurance companies started using Scenario Analysis. Under this techniques assumptions made on various condition, for example: Several interest rate scenarios were specified for the next 5 to 10 years. These specified condition like declining rates rising rates, a gradual decrease in rates followed by a sudden rise, etc. Ten or twenty scenarios could be specified in all. Assumptions were made about the performance of assets and liabilities under each scenario. They included prepayments rates on mortgages or surrender rates on insurance products. Assumptions were also made about the firms performance-the rates at which new business would be acquired for various products, demand for the product, etc. Market condition and economic factors like inflation rates and industrial cycles were also included. Based upon this assumption the performance of the firms balance sheet could be projected under each scenario. If projected performance were poor under specific scenarios, the ALM committee would adjust assets or liabilities to address the indicated exposure. Let us consider the procedure for sanctioning a commercial loan. The borrower, who approaches the bank, has to appraise the banks credit department on various parameters like industry prospects, operational efficiency, financial efficiency, management qualities and other things, which would influence the working of the company. On the basis of this appraisal, the banks would then prepare a credit grading 4

ALM IN FOREIGN BANKS sheet after covering all the aspects of the company and the business in which the company is in. Then the borrower would then be charged a certain rate of interest, which would cover the risk of lending. Nowadays a company has different reasons for doing ALM. While some companies view ALM as compliance and risk mitigation exercise, others have started using ALM as strategic framework to achieve the companys financial objectives. Some of the business reasons companies now state for implementing an effective ALM framework include gaining competitive advantages and increasing the value of the organisation.

Liquidity Management:Liquidity represents the ability to accommodate decrease in liability and to fund increase in asset. An organization has adequate liquidity when it can obtain sufficient funds, either by increasing liabilities or by converting assets, promptly and at reasonable cost. Liquidity is essential in all organization to compensate for expected and unexpected balance sheet fluctuations and to provide funds for growth. The price of liquidity is function of market conditions and market perception of the risk, both interest rate and credit risks, reflected in balance sheet and off balance sheet activities in the case of a bank. If liquidity needs are not met through liquidity asset holding, a bank may forced to restructure or acquire additional liabilities under adverse market conditions. Liquidity exposure can stem from both internally (institution-specific) and externally generated factors. Sound liquidity risk management should address both types of exposure. External liquidity risk can be geographic, systemic or instrument-specific. Internal liquidity risk relates largely to the perception of an institution in its various markets: local, regional or international, determination of the adequacy of a banks liquidity position depends upon an analysis of its: Historical funding requirement Current liquidity position Anticipated future funding needs Sources of funds Present and anticipated asset quality Present and future earnings capacity 5

ALM IN FOREIGN BANKS Present and planned capital position

As all banks are affected by changes in economical climate, the monitoring of economic and money market trends is key to liquidity planning. Sound financial management can be minimizing the negative effect of these trends while accentuating the positive ones. Management must also have an effective contingency plan that identifies minimum and maximum liquidity needs and weighs alternative courses of action designed to meet those needs. The cost of maintaining liquidity is another important prerogative. An institution that maintains a streng liquidity position may do so at the opportunity cost of generating higher earnings. The amount of liquid assets a bank should hold depends on the stability of its deposit structure and the potential for the rapid expansion of its loan portfolio. If deposit accounts are composed primarily of small stable accounts, a relatively low allowance for liquidity necessary. Additionally, management must consider the current ratings by regulatory and rating agencies when planning liquidity needs. Once liquidity needs have been determined, management must decide how to meet them through asset management, liability management, or a combination of both.

Asset Management:Many banks (primarily the smaller ones) tend to have little influence over the size of their total asset. Liquid asset enables a bank to provide funds to satisfy increased demand for loans. But banks, which rely solely on asset management, concentrate on adjusting price and availability of credit and the level of liquid asset. However, assets that are often assumed to be liquid are sometimes difficult to liquidate. For e.g. , investment securities may be pledge against public deposits or repurchase agreement, or may be heavily depreciated because of interest rate changes. Furthermore, the holding of the liquid asset for liquidity purpose is less attractive because of thin profit spreads. Asset liquidity, or how salable the bank assets are in term of both time and cost, is of primary importance in asset management. To maximize profitability, management must carefully weigh the full return on liquid asset against the higher return associated with less liquid asset. Income derived from higher yielding assets may be offset if a forced sale, at less than book value is necessary because of adverse balance sheet fluctuations.

ALM IN FOREIGN BANKS Seasonal, cyclical or other factors may cause aggregate outstanding loans and deposits to move in opposite directions and results in loan demand which exceeds available deposit funds. A bank replying strictly on asset management would restrict loan growth to that which could be supported by available deposits. The direction whether or not to use liability sources should be based on a complete analysis of seasonal, cyclic and other factors and cost involved. In addition to supplementing asset liquidity, liability sources of liquidity may serve as an alternative even when asset sources are available.

Liability Management:Liquidity needs can be met through the discretionary acquisition of funds on the basis of interest rate competition. This does not preclude the option of selling assets to meet funding needs, and conceptually, the availability of the asset and liability options should re4sult in lower liquidity maintenance cost. The alternative costs of available discretionary liabilities can be compared to the opportunity cost of selling various assets. The major difference between liquidity in larger banks and in smaller banks is that lager banks are better able to control the level and composition of their liabilities and assets. When funds are required, larger banks have wider variety of options from which to select the least costly method of generating funds. The ability to obtain additional liability represents liquidity potential. The marginal cost of liquidity and cost of incremental funds acquired are of paramount importance in evaluating liability sources of liquidity. Consideration must be given to such factors as the frequency with which the banks must regularly refinance maturing purchased liabilities, as well as an evaluation of the banks on going ability to obtain funds under normal market conditions.

ALM IN FOREIGN BANKS

Objective of the study

Though Basel Capital Accord and subsequent RBI guidelines have given a structure for ALM in banks, the Indian Banking system has not enforced the guidelines in total. The banks have formed ALCO as per the guidelines; but they rarely meet to take decisions. Public Sector banks are yet to collect 100% of ALM data because of lack of computerization in all branches. With this background, this research aims to find out the status of Asset Liability Management across all commercial banks in India with the help of multivariate technique of canonical correlation. The discussion paper has following objectives to explore: To study the Portfolio-Matching behavior of Indian Banks in terms of nature and strengths of relationship between Assets and Liability To find out the component of Assets explaining variance in Liability and viceversa To study the impact of ownership over Asset Liability management in Banks To study impact of ALM on the profitability of different bank-groups

Methodology
The study covers all scheduled commercial banks except the RRBs (Regional Rural Banks). The period of the study was from 1992 2004. The banks were grouped based on ownership structure. The groups were 1. Nationalized Banks except SBI & Associates (19) 2. SBI and Associates (8) 3. Private Banks (30) 4. Foreign Banks (36)

ALM IN FOREIGN BANKS

Reclassification of Asset and Liability

The assets and liabilities of a Bank are divided into various sub heads. For the purpose of the study, the assets were regrouped under six major heads and the liabilities were regrouped under four major heads as shown in table below. This classification is guided by prior information on the liquidity-return profile of assets and the maturity-cost profile of liabilities. The reclassified assets and liabilities covered in the study exclude other assets on the asset side and other liabilities on the liabilities side. This is necessary to deal with the problem of singularity a situation that produces perfect correlation within sets and makes correlation between sets meaningless Table 1: Reclassification of Assets Cash in hand, Bal with RBI, Bal with Banks, Money at Call and short Notice Govt. Securities and other approved securities Other than SLR such as shares, debentures, bonds, subsidiaries and others Term Loan Advances not in TL Bills purchased and discounted, cash credits, overdrafts and loans Fixed Assets Table 2: Reclassification of Liabilities Capital, Reserves and Surpluses Borrowings from RBI, banks, Other FIs both from India and Abroad Demand Deposits and Savings Bank Deposits All deposits not included in Short term

Liquid Asset SLR Securities Investments Term Loans Short term Loans Fixed Assets

Net Worth Borrowings Short Term Deposits Long Term Deposits

High Asset Liquidity Medium Low

Table 3: Liquidity-return profile of assets Liquid Assets SLR Securities Short Term Loans Investments Term Loans Fixed Asset

ALM IN FOREIGN BANKS

Canonical Correlation Analysis

Multivariate statistical technique, canonical correlation has been used to access the nature and strength of relationship between the assets and liabilities. To explore the relationship between assets and liabilities, we could merely compute the correlation between each set of assets and each set of liabilities. Unfortunately, all of these correlations assess the same hypothesis - that assets influence liabilities. Hence, a Bonferroni adjustment needs to be applied. That is, we should divide the level of significance by the number of correlations. This Bonferroni adjustment, of course, reduces the power of each correlation and thus can obscure the findings. Canonical correlation provides a means to explore all of the correlations concurrently and thus obviates the need to incorporate a Bonferroni adjustment. The technique reduces the relationship into a few significant relationships. The essence of canonical correlation Measures the strength of relationship between two sets of variables (Assets (6) & Liabilities (4) in this case) by establishing linear combination of variables in one set and a linear combinations of variables in other set. It produces an output that shows the strength of relationship between two variates as well as individual variables accounting for variance in other set. A = A1 * (Liquid Assets) + A2 * (SLR Securities) + A3 * (Investments) + A4 * (Term Loans) + A5 * (Short Term Loans) + A6 * (Fixed Assets) B = B1 * (Net Worth) + B2* (Borrowings) + B3 * (Short Term Deposits) + B4 * (Long Term Deposits) To begin with, A and B (called canonical variates) are unknown. The technique tries to compute the values of Ai and Bi such that the covariance between A & B is maximum.

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ALM IN FOREIGN BANKS

The first row (R2) is a measure of the significance of the correlation. In this case all the correlations are significant. The canonical loading is a measure of the strength of the association i.e. it is the percent of variance linearly shared by an original variable with one of the canonical variates. A loading greater that 40% is assumed to be significant. A negative loading indicates an inverse relationship. For example, for Foreign Banks, Fixed Assets (FA) under Assets has a loading of -0.903 and Net Worth (NW) under liabilities has a loading of -0.664. Since both are negative this means there is a strong correlation between FA and NW. Similarly for Foreign Banks, we can observe that there is a strong negative correlation between short term deposit with both Term Loan and Fixed Asset.

Observation
As per the summary table above, the canonical co-relation coefficients of different set of banks indicate that different banks have different degree of association among

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ALM IN FOREIGN BANKS constituents of assets and liabilities. Bank-Groups can be arranged in decreasing order of correlation: SBI & Associates Private Banks Nationalized Banks Foreign Banks Redundancy factors indicate how redundant one set of variables is, given the other set of variable which gives an idea about independent and dependent sets. This also gives an idea about the fact that whether the bank is asset managed or liability managed. Looking at the redundancy factors, the independent and dependent sets for different bank- groups can be identified.

Other than foreign bank groups, all other three have asset as their independent set. This means during the study period (1992-2004), these banks were actively managing assets and liability was dependent upon how well the assets are managed. This is in perfect consonance with the macro indicators. The interest rates were coming down all these years and banks were busy in parking their assets in different avenues where they could get maximum return. Lately, the scenario has changed in terms of interest rates. Now as there is ample liquidity in the market, banks especially the bigger one is not concerned about the liability. They can always borrow from active money market to manage their liability.

Foreign Banks The canonical function coefficient or the canonical weight of different constituents in case of foreign banks Term Loans and Fixed Assets form asset side and Net Worth and 12

ALM IN FOREIGN BANKS Short Term Deposit from liability side have significant presence with following interpretation: Very strong co-relation between Fixed Asset and Net Worth. Strong negative correlation between short term deposit with both Term Loan and Fixed Asset. This indicates Proper usage of short term deposit. Not used for long term assets or long term loans.

Private Banks
In case of private banks all constituents of asset side Liquid Assets, SLR Securities, Short Term Loans, Investments, Term Loans, and Fixed Asset are significantly explaining the co-relation while on liability side only Net Worth and Short Term Deposit are contributing. This shows how actively these banks manage their asset to generate maximum return. This relationship can be interpreted in the following ways: Very strong co-relation between FA and NW. Short Term Deposits is used for Liquid Assets, SLR and Short Term Loans. As defined above LA, SLR and STL all are highly liquid section of assets. So it is very prudent to employ short term deposit. Borrowings are used for Investment and Term Loans. As defined, borrowings are near maturity liability while investment and term loans are of long term maturity. So the private banks are using risky strategy of deploying short term fund in long term investment which is clearly against right asset-liability management. Under normal circumstances long term investment gives better returns, so this strategy is to generate additional profitability at the cost of liquidity. However as the money market has become more matured, it is easy to manage liquidity without much of risk.

Nationalized Banks

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ALM IN FOREIGN BANKS In case of nationalized banks Investment, short term loan, fixed asset contribute significantly in explaining asset part while net worth and borrowings constituent of liability is major factor. The major interpretations are: Very strong co-relation between FA and NW. Nationalized banks use Borrowings for Short Term Loans. There is negative co-relation between Borrowings and investment. More concerned with liquidity than profitability Conservative strategy ( in comparison to Private Banks) Good short term maturity/liquidity management Nationalized banks use a borrowing (which is near term maturity) for short term a loan which is effective way of ALM. However nationalized banks deploy long term liability in short term assets. This is distinctly different from private banks strategy. The nationalized banks are more concerned about liquidity than profitability.

SBI & Associates

For SBI group all constituents of Liability namely Net worth, borrowings, short term deposits and long term deposits are significant while in assets side SLR investment, Investments, Term loans and fixed assets are significant. Following can be interpreted: Very strong correlation between FA and NW Strong correlation between Borrowings and STL Correlation between Long term Deposits and Term Loans, Investment and SLR. Short Term Deposits and Short Term liabilities are correlated. Most Conservative strategy Over concerned with liquidity Use Long term funds for Long as well as medium & short term loans Among all bank-groups, SBI & Associates seem to be most prudent asset liability managements short term liability is matched with short term asset and long term assets is matched with long term liability but the same time, this group deploy long term fund for medium and short term loans. This can be called over concerned with liquidity and that too by paying a price in terms of less profitability by foregoing the opportunity to deploy them in long term assets.

Profitability Analysis of Banks

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ALM IN FOREIGN BANKS As discussed above, private banks are more aggressive in managing their portfolio for better Profit realization. So let us look into the profitability of these banks and relate that to theirALM. For this all banks are divided into two groups- Public and Private. Nationalized along with SBI are clubbed together as public banks while foreign and private banks are clubbed together as private banks. The profit figures can be compared in terms of Net Profit Margin, Return on Net Worth and Equity Multiplier.

Conclusion
Based on discussion above, it can be concluded that ownership and structure of the banks do affect their ALM procedure. The discussion paper concludes with following findings: Among all groups, SBI & Associates have best asset- liability maturity pattern. They have the best correlation between assets and liabilities Other than Foreign Banks - all other banks can be called liability managed banks. They all borrow from money market to meet their maturing liabilities Across all banks Fixed Asset and Net Worth are highly correlated All banks have proportionate Net worth and investment in Fixed Asset Private Banks is aggressive in profit generation Use short term fund (cheaper) for long term investments Risky strategy in case of liquidity Liquidity Even surplus short tem deposits they dont use it for long term Use Long term funds for Long as well as medium & short term loans reflected in their lower profitability The aggressive strategy adopted by private banks is being reflected in terms of better profitability. Private Banks have better Net Profit Margin and. Return on Net worth. Private Banks have greater equity multiplier than public sector banks which reflects extra leverage that they have. After 2002, public sector banks are catching up with private banks. Conservative Approach which is problem or rising interest rate scenario Nationalized banks (including SBI & Associates) are excessively concerned about

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