HARSHITA CHOPRA M.B.

A (FC) SEC-A ROLLNO: 25

ABSTRACT

Asset-Liability Management (ALM) is one of the important tools of risk management in

commercial banks of India. Indian banking industry is exposed to number of risk prevailed in the
market such as market risk, financial risk, interest rate risk etc. The net income of the banks is
very sensitive to these factors or risk. For this purpose Reserve bank of India (RBI), regulator of
Indian banking industry evolved the tool known as ALM. This assignment discusses issues in
asset liability management and elaborates on various categories of risk that require to be
managed. It examines strategies for asset-liability management from the asset side as well as
the liability side, particularly in the Indian context. It also discusses the specificity of financial
institutions in India and the new information technology initiatives that beneficially affect asset-
liability management. The emerging contours of conglomerate financial services and their
implications for asset-liability management are also described. The objective of the study is to
describe the concept and application of ALM technique. The research article is descriptive in
nature. The data had been collected from the secondary sources such as RBI guidelines,
reports etc. It has been found in the study that ALM is a successful tool for risk management.

INTRODUCTION

The commercial banking sector plays an important role in mobilization of deposits and
disbursement of credit to various sectors of the economy. A sound and efficient banking system
is a sine qua non for maintaining financial stability. The financial strength of individual banks,
which are major participants in the financial system, is the first line of defense against financial
risks. The banking industry in India is undergoing transformation since the beginning of
liberalization. Banks in India are venturing into non-traditional areas and generating income
through diversified activities other than the core banking activities. There have been new banks,
new instruments, new windows, new opportunities and, along with all this, new challenges.
While deregulation has opened up new vistas for banks to augment revenues, it has entailed
greater competition, reduced margins and consequently greater risks.

Banks enter into off balance sheet (OBS) transactions for extending non-fund based facilities to
their clients, balance sheet risk management and generating profits through leveraged
positions. OBS exposures of banks, especially public sector banks have witnessed a
phenomenal spurt in recent years. Scheduled commercial banks (SCBs) off-balance exposures
comprise of guarantees, letters of credit, derivatives contracts, etc. The share of off-balance
sheet exposures of SCBs in total liability increased sharply to 333.5 per cent at end-March 2008
from 68.7 per cent at end- March 2003. Public sector banks (PSBs), which are perceived to
have a low-risk appetite, have the lowest ratio of off-balance sheet exposure to total assets ratio
at 61 per cent, compared to 251 per cent for private sector banks and 2,803 per cent for foreign
banks. Commercial banks witnessed high credit growth in three years in succession staring
from the financial year 2005-06. Although, with deregulation of interest rate and opening of new
instruments and products, traditional Asset Liability Management technique has undergone a
radical change. Mismatch of Asset and Liability in various ways may affect banks viability. With
the recent global turmoil, slow down in the growth of our economy and rising off balance sheet
HARSHITA CHOPRA M.B.A (FC) SEC-A ROLLNO: 25

exposure of the banks, it is very important to explore the interrelation between two sides of the
balance sheet, asset account and liability account.

ALM-CONCEPT

ALM is a comprehensive and dynamic framework for measuring, monitoring and managing the
market risk of a bank. It is the management of structure of balance sheet (liabilities and assets)
in such a way that the net earnings from interest is maximized within the overall risk-preference
(present and future) of the institutions. The ALM functions extend to liquidly risk management,
management of market risk, trading risk management, funding and capital planning and profit
planning and growth projection. The concept of ALM is of recent origin in India. It has been
introduced in Indian Banking industry w.e.f. 1st April, 1999. ALM is concerned with risk
management and provides a comprehensive and dynamic framework for measuring, monitoring
and managing liquidity, interest rate, foreign exchange and equity and commodity price risks of
a bank that needs to be closely integrated with the banks’ business strategy. Asset-liability
management basically refers to the process by which an institution manages its balance sheet
in order to allow for alternative interest rate and liquidity scenarios.

Banks and other financial institutions provide services which expose them to various kinds of
risks like credit risk, interest risk, and liquidity risk. Asset liability management is an approach
that provides institutions with protection that makes such risk acceptable. Asset-liability
management models enable institutions to measure and monitor risk, and provide suitable
strategies for their management.

Asset-liability management is a first step in the long-term strategic planning process. Therefore,
it can be considered as a planning function for an intermediate term. In a sense, the various
aspects of balance sheet management deal with planning as well as direction and control of the
levels, changes and mixes of assets, liabilities, and capital.

SIGNIFICANCE OF ALM

 Volatility
 Product Innovations & Complexities
 Regulatory Environment
 Management Recognition

BANKING SECTOR REFORMS

The reforms were introduced in June 1991 in the wake of a balance of payments crisis, which
was certainly severe. M. Narasimham was the architect of banking sector reforms. Reforms in
the banking sector can be classified into two phases: The first phase consisted of the curative
measures, which were brought about for making the banking sector more oriented to the market
and impart competition to the environment. The second phase consisted of the preventive
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measures, which were brought about to ensure smooth functioning of the banking sector in the
long run.
The start of the reforms brought out number of skeletons and exposed the darker side of the
banking industry. Some of these were:-

 Mind blowing size of the Non Performing Assets;

 Losses in number of banks
 Overstaffing in most of the public sector banks
 Scant respect for norms for income recognition and international standard accounting
practices. During 1992-95, RBI initiated number of direct steps with an objective to
deregulate the overguarded banking sector.

Some of the steps taken by RBI were :-

1. Inventory holding norms (Tandon Committee Norms) were liberalized. Banks were given
the freedom to decide levels of holding of individual items of inventories and receivables
2. Ceiling on term loans was increasing to Rs 1000 crores for projects involving expansion /
modernization of power generation capacities.
3. To start the deregulation of interest, banks were allowed to set their own interest rate on
post-shipment export credit (in Rupees) for over 90 days. Moreover, interest rates on
loans over Rs 2, 00,000 against term deposits and on domestic deposits with maturity
periods over two years were deregulated.
4. Banks were allowed to fix their own foreign exchange open position limits. (subject to
RBI approval).
5. New delivery system for bank credit was introduced whereby, banks were asked to
bifurcate the maximum permissible bank finance of Rs 20 crores and above into loan
component of 40% (short term working capital loan) and cash credit component of 60%.

CATEGORIES OF RISK

CREDIT RISK: The risk of counter party failure in meeting the payment obligation on the
specific date is known as credit risk. Credit risk management is an important challenge for
financial institutions and failure on this front may lead to failure of banks. The recent failure of
many Japanese banks and failure of savings and loan associations in the 1980s in the USA are
important examples, which provide lessons for others. It may be noted that the willingness to
pay, which is measured by the character of the counter party, and the ability to pay need not
necessarily go together.

CAPITAL RISK: One of the sound aspects of the banking practice is the maintenance of
adequate capital on a continuous basis. There are attempts to bring in global norms in this field
in order to bring in commonality and standardization in international practices. Capital adequacy
also focuses on the weighted average risk of lending and to that extent, banks are in a position
to realign their portfolios between more risky and less risky assets.
HARSHITA CHOPRA M.B.A (FC) SEC-A ROLLNO: 25

MARKET RISK: Market risk is related to the financial condition, which results from adverse
movement in market prices. This will be more pronounced when financial information has to be
provided on a marked-to-market basis since significant fluctuations in asset holdings could
adversely affect the balance sheet of banks. In the Indian context, the problem is accentuated
because many financial institutions acquire bonds and hold it till maturity. When there is a
significant increase in the term structure of interest rates, or violent fluctuations in the rate
structure, one finds substantial erosion of the value of the securities held.

INTEREST RATE RISK: Interest risk is the change in prices of bonds that could occur as a
result of change: n interest rates. It also considers change in impact on interest income due to
changes in the rate of interest. In other words, price as well as reinvestment risks require focus.
In so far as the terms for which interest rates were fixed on deposits differed from those for
which they fixed on assets, banks incurred interest rate risk i.e., they stood to make gains or
losses with every change in the level of interest rates.

LIQUIDITY RISK: Affects many Indian institutions. It is the potential inability to generate
adequate cash to cope with a decline in deposits or increase in assets. To a large extent, it is an
outcome of the mismatch in the maturity patterns of assets and liabilities.

Regulatory Assessment of Asset/Liability Risk Management

Regulators assess risks and risk management activities in four broad categories.

Board Oversight

Effective oversight requires the board of directors to rely on sound ALM. Because ALM is
complex, some bank directors might find overseeing interest rate and liquidity risks challenging.
Senior management typically provides the board with information derived from IRR or liquidity
models that contain general assumptions and produce output reports. Much of this information
is driven by very detailed "behind-the-scenes" model inputs and assumptions. As a result, the
directors’ review is generally limited to monitoring exposures through key model output reports
and measures but with little knowledge of the assumptions behind or limitations of those
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measures. While being able to quantify and monitor risk positions is important for sound
oversight of balance-sheet exposures, effective board oversight requires more than simply
evaluating model outputs; it also requires a broad perspective on all business lines and
products, strategic goals, and risk management.

Senior Management Activities

In many cases, the board delegates routine oversight of balance-sheet risks to a committee of
senior managers known as the Asset and Liability Management (ALM) Committee or the Asset
and Liability Committee (ALCO). A community bank’s ALCO often assesses earnings,
establishes loan and deposit strategies and pricing, monitors detailed IRR exposures, and
evaluates liquidity risk exposures and contingency funding needs. Given the broad array of
activities the ALCO conducts, representation should include senior managers from the bank’s
lending, investment, deposit-gathering, and accounting functions. The ALCO should make
regular reports to the full board, so appropriate oversight by the board can be carried out.

Policies, Procedures, and Risk Limits

One of the most effective tools the board and senior management can provide to their staff is a
sound policy directive for the bank’s various activities and risk exposures. Through sound
policies, the board communicates to frontline and senior personnel its expectations with respect
to risk tolerance, desirable and undesirable activities, internal control and audit, and risk
measurement. Typically, directors develop ALM policies that consolidate the board’s
expectations for interest rate and liquidity risk exposures and oversight.

Conclusion

The community banking landscape has changed significantly in the past decade, and these
changes have required heightened attention to ALM risk management strategies and
processes. These changes, which include more products with embedded options, have required
directors and senior managers to acquire enhanced knowledge about interest rate and liquidity
risks to both manage traditional ALM risks and keep up with new ways of doing business.
Changes have also reinforced the need for directors and senior managers to reevaluate and
communicate guidance and risk tolerances to bank personnel. By ensuring that a sound
oversight structure based on strong communication of risk tolerance is in place, directors can
effectively steer the bank through challenging banking conditions whenever they occur.