ALM

Asset Liability Management is the act of planning, acquiring and directing the flow of funds through an organisation. ALM aims at liquidity and profitability taking reasonable and measured business risk. Example : A financial institution may have enough assets to payoff liabilities. But what if 50% of the liabilities are maturing within one year but only 10% of assets are maturing within same period. There is temporary insolvency due to severe liquidity crisis.

ALM & Liquidity Risk

Asset Liability Management (ALM) is one of the most important risk management functions in bank. ALM is concerned with strategic balance sheet management involving risks caused by changes in interest rate, exchange rate, credit risk and the liquidity position of a bank. Balance sheet items? The ultimate objective of ALM process is to generate adequate/ stable earnings and to steadily build an organizations equity overtime, while taking reasonable and measured business risks. Significance of ALM: Minimise liquidity and market risk.

ALM

The primary management goal is the control of interest income and expenses and the resulting net interest margin on an ongoing basis. Parameters for stabilising ALM of banks are: Net interest income (NII). The impact of volatility on short term profit is measured by NII.In order to stabilise short term profit banks have to minimise fluctuation in the NII. Net Interest Margin :NII / Average total assets This can be viewed as the spread on earning assets. Economic Equity Ratio. The ratio of share holders fund to the total assets. This assesses the sustenance capacity of the bank.

ALM Contd.

Objective of ALM: It aims at profitability through price matching while ensuring liquidity by means of maturity matching. ALM is the management of the NIM. Asset Liability Management Committee (ALCO) of the Bank. Price Matching : Rising interest rate with positive gap ( assets> liability ) & declining interest rate with a negative gap (Liability > assets ). Liquidity is ensured by grouping the assets and liabilities based on their maturity profiles.

ALCO

AlCO is a decision making unit responsible for balance sheet planning from risk- return perspective including the strategic management of interest rate and liquidity risk. ALCO functions include inter alia product pricing for both deposits and advances, desired maturity profile and mix of the incremental assets and liabilities etc.

Liquidity Management

Banks liquidity position depends upon an analysis of the following factors: Historical funding requirements Current liquidity position Anticipated future funding needs Sources of funds Options for reducing funding needs Present and anticipated assets quality Present and future earning capacity Present and planned capital position

Contd.

Measuring and managing Liquidity risk : Necessary steps are 1. Developing a structure for managing liquidity risk 2. Setting tolerance level and limit for liquidity risk 3. Measuring and managing liquidity risk Board should monitor the performance and liquidity risk profile of the bank periodically reviewing the relevant information on inflow and outflow of cash. ALCO to formulate liquidity management structure and execute effectively the liquidity strategy, policies and procedures.

Contd.

Setting tolerance level and limit for liquidity risk : Limit could be set on the following The cumulative cash flow mismatches over particular periods say next day, next week, next month, next year should be calculated 8 time buckets as prescribed by the RBI. The residual maturity profile of assets and liabilities will be such that mismatch level for time bucket of 1-14 days and 15-28 days remain around 20%of cash outflow in each time bucket.

Contd.
Measuring and managing Liquidity Risk : (i) Stock approach (ii ) Flow approach Under stock approach various ratios are calculated to assess the liquidity position of a bank. Under flow approach the three major dimensions are: (a) Measuring and managing net funding requirements (b) Managing market access, and Contingency planning

Stock Approach

Ratio of core deposit to total assets Net loans to total deposit ratio. Ratio of time deposit to total deposit. Ratio of volatile liabilities( Market borrowings)to total assets Ratio of short time liabilities to liquid assets Ratio of liquid assets to total assets Ratio of short term liabilities to total assets Ratio of prime asset to total assets

Flow Approach

It is called gap method of measuring and managing liquidity being practiced by Indian banks. It requires the preparation of structural liquidity gap report. In this method net funding requirement is calculated on the basis of residual maturities of assets and liabilities. Difference of outflow and inflow of cash in the future time buckets is calculated. Incase the gap is negative the bank has to manage the short fall. The analysis of net funding requirements involves the construction of a maturity ladder. RBI has prescribed 8 time buckets for liquidity management by banks.