Asset Liability Management

Meaning and concept of asset liability

management, maturity mismatch,
interest sensitive assets and liability, interest
rate risk, determination of interest rate,
interest spread,
Gap analysis,
Assets liability management committee
(ALCO),
roles and responsibility of ALCO.
 Evolution
• In the 1940s and the 1950s, there was an abundance of funds in
banks in the form of demand and savings deposits. Hence, the focus
then was mainly on asset management

• But as the availability of low cost funds started to decline, liability

management became the focus of bank management efforts

• In the 1980s, volatility of interest rates in USA and Europe caused

the focus to broaden to include the issue of interest rate risk. ALM
began to extend beyond the bank treasury to cover the loan and
deposit functions

• Banks started to concentrate more on the management of both sides

of the balance sheet
 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.
 What is Asset Liability Management?
• 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 models enable institutions to
measure and monitor risk, and provide suitable strategies
for their management.
 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 ration.
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
 Why ALM ?
 Banks exposed to credit and market risks in view of
asset-liability transformation
 Risks increased with liberalization and growing
integration of domestic markets with external markets
 Banks now operate in deregulated environment and are
required to determine interest rates on various products
 Need to maintain balance among spread, profitability
and long-term viability
 Increasing volatility in domestic interest rates as well as
foreign exchange rates
 New financial product innovation
 Why ALM ?.. Contd..
 Increased level of awareness among top management
- market risks, interest rate movements
 Intense competition for business involving both assets
and liabilities
 Regulatory initiatives
 International initiative – Basel Committee
 Thus, a call for structured and comprehensive
measures for institutionalizing an integrated risk
management system
 3 tools used by banks for ALM
ALM information
systems

ALM Organization

ALM Process
 ALM Information Systems
• Usage of Real Time information system to gather the information
about the maturity and behavior of loans and advances made by all
other branches of a bank
• ABC Approach :
– analysing the behaviour of asset and liability products in the top
branches as they account for significant business
– then making rational assumptions about the way in which assets
and liabilities would behave in other branches
– The data and assumptions can then be refined over time as the
bank management gain experience
• The spread of computerisation will also help banks in accessing
data.
 ALM Organization
• The board should have overall responsibilities and should set the limit for
liquidity, interest rate, foreign exchange and equity price risk
• The Asset - Liability Committee (ALCO)
– ALCO, consisting of the bank's senior management (including CEO)
should be responsible for ensuring adherence to the limits set by the Board
– Is responsible for balance sheet planning from risk - return perspective
including the strategic management of interest rate and liquidity risks
– The role of ALCO includes product pricing for both deposits and
advances, desired maturity profile of the incremental assets and liabilities,
– It will have to develop a view on future direction of interest rate
movements and decide on a funding mix between fixed vs floating rate
funds, wholesale vs retail deposits, money market vs capital market
funding, domestic vs foreign currency funding
– It should review the results of and progress in implementation of the
decisions made in the previous meetings
ALM Process

Risk Parameters

Risk Identification

Risk Measurement

Risk Management

Risk Policies and Tolerance

Level
 Categories of Risk
• Risk is the chance or probability of loss or damage
Credit Risk Market Risk Operational Risk
Transaction Risk /default Commodity risk Process risk
risk /counterparty risk
Portfolio risk Interest Rate risk Infrastructure risk
/Concentration risk
Settlement risk Forex rate risk Model risk

Equity price risk Human risk

Liquidity risk
But under ALM risks that are typically
managed are….

Liquidity
Currency Risk
Risk

Interest
Rate
Risk

Will now be discussed in detail

 Liquidity Risk
• Liquidity risk arises from funding of long term assets by short
term liabilities, thus making the liabilities subject to refinancing

Funding risk Time risk Call Risk

• Arises due to • It arises when an • Due to
unanticipated asset turns into a crystallisation of
withdrawals of the NPA. So, the contingent
deposits from expected cash flows liabilities and
wholesale or retail are no longer unable to undertake
clients available to the profitable business
bank. opportunities when
available.
 Liquidity Management
Bank’s liquidity management is the process of
generating funds to meet contractual or relationship
obligations at reasonable prices at all times.

Liquidity Management is the ability of bank to ensure

that its liabilities are met as they become due

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
Analysis of following factors throw light on a bank’s
adequacy of liquidity position:
a. Historical Funding requirement
b. Current liquidity position
c. Anticipated future funding needs
d. Sources of funds
e. Options for reducing funding needs
f. Present and anticipated asset quality
g. Present and future earning capacity and
h. Present and planned capital position
 Funding Avenues
To satisfy funding needs, a bank must perform one or a
combination of the following:

a. Dispose off liquid assets

b. Increase short term borrowings
c. Decrease holding of less liquid assets
d. Increase liability of a term nature
e. 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

• Time Risk
- Need to compensate for non-receipt of
expected inflows of funds

• Call Risk
- Crystallization of contingent liability
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 30 Days- 3 Mths - 6 Mths - 1Year - 3 3 Years - Over 5
1-14Days Days 3 Month 6 Mths 1Year Years 5 Years Years Total

Capital 200 200

Liab-fixed Int 300 200 200 600 600 300 200 200 2600
Liab-floating Int 350 400 350 450 500 450 450 450 3400
Others 50 50 0 200 300
Total outflow 700 650 550 1050 1100 750 650 1050 6500
Investments 200 150 250 250 300 100 350 900 2500
Loans-fixed Int 50 50 0 100 150 50 100 100 600
Loans - floating 200 150 200 150 150 150 50 50 1100
Loans BPLR Linked 100 150 200 500 350 500 100 100 2000
Others 50 50 0 0 0 0 0 200 300
Total Inflow 600 550 650 1000 950 800 600 1350 6500
Gap -100 -100 100 -50 -150 50 -50 300 0
Cumulative Gap -100 -200 -100 -150 -300 -250 -300 0 0
Gap % to Total Outflow
-14.29 -15.38 18.18 -4.76 -13.64 6.67 -7.69 28.57
 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 Percentage
(In Cr)

I. Deposits 15200 100

a. Up to 1 year 8000 52.63
b. Over 1 yr to 3 yrs 6700 44.08
c. Over 3 yrs to 5 yrs 230 1.51
d. Over 5 years 270 1.78
II. Borrowings 450 100
a. Up to 1 year 180 40.00
b. Over 1 yr to 3 yrs 00 0.00
c. Over 3 yrs to 5 yrs 150 33.33
d. Over 5 years 120 26.67
III. Loans & Advances 8800 100
a. Up to 1 year 3400 38.64
b. Over 1 yr to 3 yrs 3000 34.09
c. Over 3 yrs to 5 yrs 400 4.55
d. Over 5 years 2000 22.72
Iv. Investment 5800 100
a. Up to 1 year 1300 22.41
b. Over 1 yr to 3 yrs 300 5.17
c. Over 3 yrs to 5 yrs 900 15.52
d. Over 5 years 3300 56.90
 SUCCESS OF ALM IN BANKS :
PRE - CONDITIONS

1. Awareness for ALM in the Bank staff at all levels–

supportive 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.
 Currency Risk
• The increased capital flows from different nations
following deregulation have contributed to increase in the
volume of transactions
• Dealing in different currencies brings opportunities as well
as risk
• To prevent this banks have been setting up overnight
limits and undertaking active day time trading
• Value at Risk approach to be used to measure the risk
associated with forward exposures. Value at Risk estimates
probability of portfolio losses based on the statistical
analysis of historical price trends and volatilities.
 Interest Rate Risk Management
• Interest Rate risk is the exposure of a bank’s 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 bank’s earnings and capital base.

• Changes in interest rates also affect the underlying

value of the bank’s 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).

• NIM = (Interest income – Interest expense) / Earning

assets

• 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
Basis

Interest
Options
Rate Re-pricing

Risk
Yield
• Re-pricing Risk: The assets and liabilities could re-price at different dates
and might be of different time period. For example, a loan on the asset side
could re-price at three-monthly intervals whereas the deposit could be at a
fixed interest rate or a variable rate, but re-pricing half-yearly

• Basis Risk: The assets could be based on LIBOR rates whereas the
liabilities could be based on Treasury rates or a Swap market rate

• Yield Curve Risk: The changes are not always parallel but it could be a
twist around a particular tenor and thereby affecting different maturities
differently

• Option Risk: Exercise of options impacts the financial institutions by

giving rise to premature release of funds that have to be deployed in
unfavourable market conditions and loss of profit on account of foreclosure
of loans that earned a good spread.
 Risk Measurement Techniques

Various techniques for measuring exposure of banks

to interest rate risks
• Maturity Gap Analysis
• Duration
• Simulation
• Value at Risk
 Maturity gap method
THREE OPTIONS:
• A) Rate Sensitive Assets > Rate Sensitive Liabilities=
Positive Gap
• B) Rate Sensitive Assets < Rate Sensitive Liabilities =
Negative Gap
• C) Rate Sensitive Assets = Rate Sensitive Liabilities =
Zero Gap
 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

• The basic weakness with this model is that this method

takes into account only the book value of assets and
liabilities and hence ignores their market value.
 Duration Analysis
• It basically refers to the average life of the asset or the liability

• It is the weighted average time to maturity of all the preset

values of cash flows

• The larger the value of the duration, the more sensitive is the
price of that asset or liability to changes in interest rates

• As per the above equation, the bank will be immunized from

interest rate risk if the duration gap between assets and the
liabilities is zero.
 Simulation
• Basically simulation models utilize computer power to provide
what if scenarios, for example: What if:

– The absolute level of interest rates shift

– Marketing plans are under-or-over achieved
– Margins achieved in the past are not sustained/improved
– Bad debt and prepayment levels change in different interest
rate scenarios
– There are changes in the funding mix e.g.: an increasing
reliance on short-term funds for balance sheet growth

• This dynamic capability adds value to this method and improves

the quality of information available to the management
 Value at Risk
• Refers to the maximum expected loss that a bank can suffer in
market value or income:
– Over a given time horizon,
– Under normal market conditions,
– At a given level or certainty

• It enables the calculation of market risk of a portfolio for which no

historical data exists. VaR serves as Information Reporting to
stakeholders

• It enables one to calculate the net worth of the organization at any

particular point of time so that it is possible to focus on long-term
risk implications of decisions that have already been taken or that
are going to be taken.
 Asset and liability management committee
(ALCO)
• A bank's asset and liability management committee
(ALCO) coordinates all policy decisions and
strategies that determine a bank's risk profit and profit
objectives.
• Interest rate risk management is the primary
responsibility of this committee.
 ALCO - Role & Responsibilities
• ALCO decision making unit- Responsible for
balance sheet planning from risk return
perspective
• Monitoring the market risk levels by ensuring
adherence to the various risk limits set by the bank
• Articulating the current interest rate view and a
view on future direction of interest rate movements

• Deciding the business strategy of the bank,

consistent with the interest rate view, budget and
pre-determined risk management objectives
 ALCO – Role & Responsibilities
• Determining the desired maturity profile and mix
of assets and liabilities
• Product pricing for both assets and liabilities side
• Deciding the funding strategy i.e. source and mix
of liabilities or sale of assets
• Reviewing implementation of decisions made in
the previous meeting
 Composition of ALCO
• The size of ALCO depends on size of institution,
business mix and organizational complexity
• CEO to head the Committee
• Chiefs of Investment, Credit, Resource Management,
Funds Management/ Treasury, Banking and
Economic Research to be members of the
Committee
• Head of Technology Division be an invitee
• Some banks may have sub-committees and support
groups
• Management committee to oversee and review
THANK YOU