Asset Liability Management in Banks

[Module A]

Presentation

Components of a Bank Balance sheet

Liabilities
1. 2. 3. 4. 5. Capital Reserve & Surplus Deposits Borrowings Other Liabilities

Assets
1. Cash & Balances with RBI 2. Bal. With Banks & Money at Call and Short Notices 3. Investments 4. Advances 5. Fixed Assets 6. Other Assets

Contingent Liabilities

Components of Liabilities 1.Capital:

Capital represents owners contribution/stake in the bank.
- It serves as a cushion for depositors and creditors. - It is considered to be a long term sources for the bank.

Components of Liabilities
2. Reserves & Surplus
Components under this head includes:
I. II. III. III. IV. Statutory Reserves Capital Reserves Share Premium Revenue and Other Reserves Balance in Profit and Loss Account

Components of Liabilities
3. Deposits This is the main source of banks 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

Components of Liabilities
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

Components of Liabilities
5. Other Liabilities & Provisions
It is grouped as under: I. II. III. IV. V. Bills Payable Inter Office Adjustments (Net) Interest Accrued Unsecured Redeemable Bonds (Subordinated Debt for Tier-II Capital) Others(including provisions income tax, TDS, Interest Tax, Provisions etc.)

Components of Assets
1. Cash & Bank Balances with RBI
I. Cash in hand (including foreign currency notes) II. Balances with Reserve Bank of India In Current Accounts In Other Accounts

Components of Assets
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

Components of Assets
3. Investments
A major asset item in the banks balance sheet. Reflected under 6 buckets as under: I. Investments in India in : *
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

Components of Assets
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

Components of Assets
5. Fixed Asset
I. II. Premises Other Fixed Assets (Including furniture and fixtures)

6. Other Assets
I. II. III. IV. V. VI. Interest accrued Tax paid in advance / tax deducted at source (Net of Provisions) Stationery and Stamps Non-banking assets acquired in satisfaction of claims Deferred Tax Asset (Net) Others

Contingent Liability
Banks obligations under LCs, Guarantees, Acceptances on behalf of constituents and Bills accepted by the bank are reflected under this heads. It also includes Un-called part of Partly Paid Investment.

Banks Profit & Loss Account

A banks profit & Loss Account has the following components: Income: This includes Interest Income and Other Income. Expenses: This includes Interest Expended, Operating Expenses and Provisions & contingencies.

I. II.

Components of Income
1. INTEREST EARNED
I. II. III. IV. Interest/Discount on Advances / Bills Income on Investments Interest on balances with Reserve Bank of India and other inter-bank funds Others

Components of Income
2. OTHER INCOME
I. II. III. IV. V. VI. VII. Commission, Exchange and Brokerage Profit on sale of Investments (Net) Profit/(Loss) on Revaluation of Investments Profit on sale of land, buildings and other assets (Net) Profit on exchange transactions (Net) Income earned by way of dividends etc. from subsidiaries and Associates abroad/in India Miscellaneous Income

Components of Expenses
1. INTEREST EXPENDED
I. II. III. Interest on Deposits Interest on Reserve Bank of India / Inter-Bank borrowings Others

Components of Expenses
2. OPERATING EXPENSES
I. II. III. IV. V. VI. VII. VIII. IX. X. XI. XII. Payments to and Provisions for employees Rent, Taxes and Lighting Printing and Stationery Advertisement and Publicity Depreciation on Bank's property Directors' Fees, Allowances and Expenses Auditors' Fees and Expenses (including Branch Auditors) Law Charges Postages, Telegrams, Telephones etc. Repairs and Maintenance Insurance Other Expenditure

Provisions & Contingencies

Provision Made for: - Bad & Doubtful debts - Taxation - Depreciation/Diminution in value of Investment - Other Provisions

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.

Financial Intermediation-Qualitative Asset Transformation Liquidity and payment intermediation

Liquid deposits vs illiquid credits

Maturity intermediation
Short-term deposits vs long-term credits

Denomination intermediation
Small-denomination deposits vs large credits

Diversification intermediation
Investors have a claim against a well-diversified portfolio

Information intermediation
FIs acquire information about the borrowers, provide them with funds, and monitor their performance Incentives for monitoring: rents or reputation

Significance of ALM
Volatility Product Innovations & Complexities Integration of Markets Regulatory Environment Management Recognition

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. The parameters for stabilizing ALM system are: 1. Net Interest Income (NII) 2. Net Interest Margin (NIM) 3. Economic Equity Ratio

RBI DIRECTIVES
Issued draft guidelines on 10th Sept 1998. Final guidelines issued on 10th implementation of ALM w.e.f. 01.04.99. Feb99 for

To begin with 60% of asset & liabilities are covered; 100% from 01.04.2000. Initially Gap Analysis was applied in the first stage of implementation. Disclosure to Balance Sheet on maturity pattern on Deposits, Borrowings, Investment & Advances w.e.f. 31.03.01

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

Adequacy of liquidity position for a bank

a. b. c. d. e. f. g. h. Analysis of following factors throw light on a banks adequacy of liquidity position: Historical Funding requirement Current liquidity position Anticipated future funding needs Sources of funds Options for reducing funding needs Present and anticipated asset quality Present and future earning capacity and Present and planned capital position

Factors that may affect a banks liquidity include: A decline in earnings An increase in Non-Performing assets Deposit concentration A down grading by Rating Agencies Expanded Business Opportunity Acquisitions New Tax initiatives

Funding Avenues
To satisfy funding needs, a bank must perform one or a combination of the following: a. b. c. d. e. f. Dispose off liquid assets Increase short term borrowings Decrease holding of less liquid assets Increase liability of a term nature Securitization of Assets 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
Arises due to: Fraud Causing substantial loss Systemic risk Loss of Confidence Liabilities in Foreign Currencies

Other categories of liquidity risk

Time Risk - Need to compensate for non-receipt of expected inflows of funds
Arises due to: - Severe deterioration in asset quality - Standard assets turning into NPA - Temporary Problem in recovery - Time involved in managing liquidity

Other categories of liquidity risk

Call Risk - Crystallization of contingent liability
Arises due to:
- Conversion of non-fund based limit to fund based limit - Swaps and Options

Measuring & Managing Liquidity Risk

Steps necessary for managing liquidity risks in Banks 1. Developing a structure for managing liquidity risk 2. Setting tolerance level and limit for liquidity risk 3. Measuring and Managing Liquidity Risk

Setting tolerance level and limit for liquidity risk

Limits could be set on the following lines:
1. 2. 3. 4. 5. 6. Cumulative cash flow mismatches over particular period taking conservative view of marketable liquid assets Liquid assets as percentage of short-term liabilities A limit on Loan to deposit ratio A limit on loan to capital ratio Primary sources for meeting funding needs should be quantified Flexible liquidity provision to be maintained to sustain operations

Measuring and Managing Liquidity Risk

Measuring and Managing funding requirement can be done through two approaches: 1. Stock Approach 2. Flow Approach

Stock Approach
This Approach is based on the level of assets and liabilities as well as Off-Balance sheet exposures on a particular date. 1. Ratio of Core Deposit to total Assets:
Core Deposit/Total Asset: More the ratio better it is because core deposit treated to be the stable source of liquidity.

2. Net Loans to Total deposits Ratio:

Net Loans/Total Deposit: It reflects the ratio of loans to Public Deposits or core deposits. Lower the ratio is the better.

Stock Approach
3. Ratio of Time Deposit to Total Deposits: Time Deposits/Total Deposits: Higher the Ratio better 4. Ratio of Volatile liabilities to total assets Volatile Liabilities/Total Assets Lower the Ratio the Better 5. Ratio of Short Term Liabilities to Liquid Assets: Short Term Liabilities/Liquid Assets: Lower the Ratio the better

Stock Approach
6. Ratio of Liquid Assets to Total Assets:
Higher the Ratio the better

7. Ratio of Short Term Liability/Total Assets:

A lower ratio is desirable

8. Ratio of Prime Asset to Total Asset:

Higher the ratio the better

9. Ratio of Marketable liability to total asset:

Lower the ratio better N.B>Indian Banks do not follow this approach

Flow Approach
The Frame work for assessing and managing bank liquidity through flow approach has three major dimensions: 1. Measuring and Managing net funding requirements 2. Managing market access, and 3. Contingency Planning

Statement of Structural Liquidity

All Assets & Liabilities to be reported as per their maturity profile into 8 maturity Buckets:
i. 1 to 14 days ii. 15 to 28 days iii. 29 days and up to 3 months iv. Over 3 months and up to 6 months v. Over 6 months and up to 1 year vi. Over 1 year and up to 3 years vii. Over 3 years and up to 5 years viii. Over 5 years

STATEMENT OF STRUCTURAL LIQUIDITY

Places all cash inflows and outflows in the maturity ladder as per residual maturity Maturing Liability: cash outflow Maturing Assets : Cash Inflow Classified in to 8 time buckets Mismatches in the first two buckets not to exceed 20% of outflows Shows the structure as of a particular date Banks can fix higher tolerance level for other maturity buckets.

An Example of Structural Liquidity Statement

15-28 1-14Days Days 30 Days- 3 Mths - 6 Mths - 1Year - 3 3 Years - Over 5 3 Month 6 Mths 1Year Years 5 Years Years Total

300 350 50 700 200 50 200 Loans BPLR Linked 100 Others 50 Total Inflow 600 Gap -100 Cumulative Gap -100 Gap % to Total Out14.29

Capital Liab-fixed Int Liab-floating Int Others Total outflow Investments Loans-fixed Int Loans - floating

200 400 50 650 150 50 150 150 50 550 -100 -200

-15.38

200 600 600 300 200 350 450 500 450 450 0 550 1050 1100 750 650 250 250 300 100 350 0 100 150 50 100 200 150 150 150 50 200 500 350 500 100 0 0 0 0 0 650 1000 950 800 600 100 -50 -150 50 -50 -100 -150 -300 -250 -300
18.18 -4.76 -13.64 6.67 -7.69

200 200 450 200 1050 900 100 50 100 200 1350 300 0
28.57

200 2600 3400 300 6500 2500 600 1100 2000 300 6500 0 0

ADDRESSING THE MISMATCHES

Mismatches can be positive or negative Positive Mismatch: M.A.>M.L. and Negative Mismatch M.L.>M.A. In case of +ve mismatch, excess liquidity can be deployed in money market instruments, creating new assets & investment swaps etc. For ve mismatch,it can be financed from market borrowings (Call/Term), Bills rediscounting, Repos & deployment of foreign currency converted into rupee.

STRATEGIES
To meet the mismatch in any maturity bucket, the bank has to look into taking deposit and invest it suitably so as to mature in time bucket with negative mismatch. The bank can raise fresh deposits of Rs 300 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.

Maturity Pattern of Select Assets & Liabilities of A Bank Liability/Assets Rupees (In Cr) 15200 8000 6700 230 270 450 180 00 150 120 8800 3400 3000 400 2000 5800 1300 300 900 3300 In Percentage

I. Deposits a. Up to 1 year b. Over 1 yr to 3 yrs c. Over 3 yrs to 5 yrs d. Over 5 years II. Borrowings a. Up to 1 year b. Over 1 yr to 3 yrs c. Over 3 yrs to 5 yrs d. Over 5 years III. Loans & Advances a. Up to 1 year b. Over 1 yr to 3 yrs c. Over 3 yrs to 5 yrs d. Over 5 years Iv. Investment a. Up to 1 year b. Over 1 yr to 3 yrs c. Over 3 yrs to 5 yrs d. Over 5 years

100 52.63 44.08 1.51 1.78 100 40.00 0.00 33.33 26.67 100 38.64 34.09 4.55 22.72 100 22.41 5.17 15.52 56.90

Interest Rate Sensitivity Analysis

Structural Liquidity Statement is the basis for IRS analysis. All off balance sheet items are excluded except Repos, Reverse Repos and SWAPs. Non-sensitive assets / liabilities are shifted to non-sensitive bucket (like Capital, Reserves, Fixed Assets etc). A perception of likely interest rate scenario is formed. Accordingly, repricing effect is assessed for all RSA / RSL. Rate sensitive gaps are assessed from the analysis.

STATEMENT OF INTEREST RATE SENSITIVITY

Generated by grouping RSA,RSL & OFFBalance sheet items in to various (8)time buckets.
RSA: MONEY AT CALL ADVANCES ( BPLR LINKED ) INVESTMENT RSL DEPOSITS EXCLUDING CD BORROWINGS

Balance Sheet looked at from Interest Rates: Whether Interest bearing No No No Yes Fixed Discretionary pricing for High Value deposits & Inter bank items Fixed / Floating Rate

Balance Sheet Items Liabilities Capital Reserves & Surplus Deposits - Current Deposits - Savings Deposits

Remarks

- Term Deposits Borrowings - From within India - From Outside India Other Liabilities - Interest Payable - Subordinated Debts - Others

Yes Yes Yes Yes Yes NO

Fixed Fixed Generally Fixed Fixed Fixed

Sometimes, floating, linked to LIBOR

In a few cases, this is floating rate item

Balance Sheet looked at from Interest Rates: Whether Interest bearing Fixed / Floating Rate

Balance Sheet Items Assets Cash on Hand

Remarks

No Interest only on CRR withdrawn since 24-06-2006

Balances with RBI Balances with Other Banks - in current accounts - Call money, Reverse Repo etc

No

No Yes Fixed However, shares etc do not earn interest

Investments Loans and Advances Fixed Assets Other Assets

Yes Yes No No

Fixed Fixed / Floating

MATURITY GAP METHOD (IRS)

THREE OPTIONS: A) RSA>RSL= Positive Gap B) RSL>RSA= Negative Gap C) RSL=RSA= Zero Gap

IRS & Interest Rate Scenario

Impact of Interest Rate Changes on NII
Rising Interest Stable Interest Falling Interest Rate Scenario Rate Scenario Rate Scenario Negative Mis Matches in IRS Mis Match in IRS is NIL

Adverse

No Impact Favourable

No Impact No Impact No Impact Adverse

Positive Mis Matches in IRS Favourable No Impact

Interest Rate Risk Management

Interest Rate risk is the exposure of a banks 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 banks earnings and capital base. Changes in interest rates also affect the underlying value of the banks assets, liabilities and off-balance-sheet item.

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 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.

Interest Rate Risk

The risk that the returns on funds to be reinvested will fall below the originally anticipated returns.

Liabilities

2 years

Assets

1 year

Measurement of Interest Rate Risk

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.

MARKET RISK: Measure, Monitor & Manage Value at Risk Value-at-Risk Value-at-Risk is a measure of Market Risk, which measures the maximum loss in the market value of a portfolio with a given confidence
Value at Risk
.022 .016 .011 .005 .000 1.5 2.9 4.3 5.6 Certainty is 95.00% from 2.6 to +Infinity 7.0 433 324.7 216.5 108.2 0

VaR is denominated in units of a currency or as a percentage of portfolio holdings For e.g.., a set of portfolio having a current value of say Rs.100,000- can be described to have a daily value at risk of Rs. 5000- at a 99% confidence level, which means there is a 1/100 chance of the loss exceeding Rs. 5000/- considering no great paradigm shifts in the underlying factors. It is a probability of occurrence and hence is a statistical measure of risk exposure

The Success of ALM rests of effective existence of:

ALM Information System - Management Information System (MIS) - Information Availability, Accuracy, Adequacy and expediency ALM Organization ALM Process

ALM Information System

Information is key to the ALM Process Due to varied nature of business focus among Public/Private/Foreign Banks, uniform practice of ALM System not feasible Data Accuracy, Quality & timeliness are key to ALM information system Banks with wide geographical reach and manual system required to follow ABC Approach so as to cover maximum assets and liabilities for analyzing their behaviour. The level of computerization, use of Core Banking Solution will ease the ALM Information System.

ALM Organization
ALCO Committee
Should be headed by CEO/CMD or ED Members include head of Investment, Credit, Funds & Treasury (Fx & Domestic), International Banking and Economic Research can be members. In addition, head of IT should also be an invitee for building up of MIS/Computerization. The Management Committee of the Board or any other specific Committee constituted by the Board should oversee the implementation of system & review its functioning periodically.

ALM Process
The Scope of ALM functions can be described as follows: - Liquidity Management - Management of Interest Rate Risk/Market Risk - Funding & Capital Planning - Profit planning and Growth Projections - Trading Risk Management

SUCCESS OF ALM IN BANKS : PRE - CONDITIONS

1. Awareness for ALM in the Bank staff at all levelssupportive Management & dedicated Teams. 2. Method of reporting data from Branches/ other Departments. (Strong MIS). 3. Computerization-Full computerization, networking. 4. Insight into the banking operations, economic forecasting, computerization, investment, credit. 5. Linking up ALM to future Risk Management Strategies.