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Asset Liability Management in India Banks
The document discusses asset liability management (ALM) in banks, focusing on the balance sheet components for assets and liabilities. It explains how ALM helps manage risks such as credit, interest, and liquidity risks, emphasizing the importance of aligning assets and liabilities to mitigate financial risks. The document also outlines the historical evolution of ALM practices and various tools and techniques for effective risk management.
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Asset Liability Management in India Banks
- 1. Asset Liability Management (ALM)in Banks ABHIJEET V DESHMUKH www.abhijeetdeshmukh.com
- 2. Balance Sheet Afinancial statement that summarizes a company's assets, liabilities and shareholders' equity at a specific point in time. These three balance sheet segments give investors an idea as to what the company owns and owes, as well as the amount invested by shareholders. The balance sheet adheres to the following formula: Assets = Liabilities + Shareholders' Equity
- 3. Components of aBank Balance Sheet Liabilities Assets 1. Capital 2. Reserve & Surplus 3. Deposits 4. Borrowings 5. Other Liabilities 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 A Bank’s profit & Loss Account has the following components: I. Income: This includes Interest Income and Other Income. II. Expenses: This includes Interest Expended, Operating Expenses and Provisions & contingencies.
- 4. Introduction to ALM A monthly mortgage is a common example of a liability that a consumer has to fund out of his or her current cash inflow. Each month, the individual faces the task of having sufficient assets to pay that mortgage. For e.g. if Joe in the example is not able to generate enough funds through Pizza delivery he wont be able to pay his Car Mortgage. Slowly his Net Worth will be wiped out and his assets wont be able to support his liabilities.
- 5. Bank have similarchallenges, but on a much more complex scale. Consider a bank that borrows USD 100MM at 3.00% for a year and lends the same money at 3.20% to a highly-rated borrower for 5 years. The net transaction appears profitable—the bank is earning a 20 basis point spread—but it entails considerable risk. At the end of a 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 3.20 it is earning on its loan. Suppose, at the end of a year, an applicable 4-year interest rate is 6.00%. The bank is in serious trouble. It is going to be earning 3.20% on its loan and paying 6.00% on its financing. The problem in this example was caused by a mismatch between assets and liabilities. Example
- 6. What is AssetLiability Management? In its simplest form, asset/liability management entails managing assets and cash inflows to satisfy various obligations/liabilities/cash outflows. Some prefer the phrase "surplus/Net Worth optimization" as better term to explain the need to maximize assets available to meet increasingly complex liabilities. It is a form of risk (credit risk, interest risk, and liquidity risk) management whereby one endeavors to mitigate or hedge the risk of failing to meet these obligations. 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 Asset-liability management models enable institutions to measure and monitor risk, and provide suitable strategies for their management. ALM Process stabilizes short-term profits, long-term earnings and long-term substance of the bank and thus increases Bank’s Profit, in addition to managing risk
- 7. ALM must strikea balance… Company Objectives Risk Tolerance Shareholder Expectations Regulatory Requirements Accounting Requirements Investment Markets Policyholder Interests
- 8. Evolution In the1940s and the 1950s, there was an abundance of funds in banks in the form of demand and savings deposits & Fed monetary policy kept interest rates stable. Hence, the focus then was mainly on asset management. As loan demand increased in the 1960s during bouts of inflation associated with the Vietnam War, banks for first time started to use liability management. Things started to change in the 1970s, which was a period of volatile interest rates that continued into the early 1980s. Late 1980’s, the availability of low cost funds started to decline, along with volatility of interest rates in USA and Europe caused the focus to broaden to include the issue of interest rate risk. In 21st century, Globalization of financial markets, Deregulation of Interest Rates, Multi- currency Balance Sheet, Prevalence of Inverted Curve, Basis Risk and Embedded Option Risk & Integration of Markets – Money Market, Forex Market, Government Securities Market, ALM began to extend beyond the bank treasury to cover the loan and deposit functions and thus the management of both sides of the balance sheet
- 9. Parameters for stabilizingALM Net Interest Income (NII) = Interest Income-Interest Expenses. Net Interest Margin (NIM) = Net Interest Income/Average Total/Earning Assets Economic Equity Ratio The ratio of the shareholders funds to the total assets measures the shift in the ratio of owned funds to totals funds .This fact assesses the sustainability / capacity of the bank.
- 10. Three Tools usedby banks for ALM ALM Information System ALM Organization ALM Process
- 11. 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/speed of computerisation will also help banks in accessing data.
- 12. ALM Organization Theboard 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
- 13. ALM Process Risk Parameters RiskIdentification Risk Measurement Risk Management Risk Policies and Tolerance Level
- 14. Categories of Risk Risk is the chance or probability of loss or damage Credit Risk Market Risk Operational Risk Transaction Risk /default risk /counterparty risk Commodity risk Process risk Portfolio risk /Concentration risk Interest Rate risk Infrastructure risk Settlement risk Forex rate risk Model risk Equity price risk Human risk Liquidity risk
- 15. Risks managed byALM are…. Will now be discussed in detail Interest Rate Risk Currency Risk Liquidity Risk
- 16. Liquidity Risk Definition Liquidityrisk refers to the risk that the institution might not be able to generate sufficient cash flow to meet its financial obligations Effect Risk to bank’s earnings Reputational risk Contagion effect Liquidity crisis can lead to runs on Banks & their failures can affect Global economies
- 17. Factors affecting LiquidityRisk Over extension of credit High level of NPAs Poor AML Policy Poor asset quality Mismanagement Reliance on a few wholesale depositors Large undrawn loan commitments Lack of appropriate liquidity policy & contingent plan
- 18. Liquidity Risk Liquidityrisk arises from funding of long term assets by short term liabilities, thus making the liabilities subject to refinancing • Arises due to unanticipated withdrawals of the deposits from wholesale or retail clients Funding risk • It arises when an asset turns into a NPA. So, the expected cash flows are no longer available to the bank. Time risk • Due to crystallisation of contingent liabilities (e.g. Law suite expense) or new demand of loans, Bank is unable to undertake profitable business opportunities when available. Call Risk
- 19. Liquidity Risk Management Bank’s liquidity management is the process of generating funds to meet contractual or relationship obligations at reasonable prices at all times. It can be managed from either the asset side of the balance sheet or the liability side. Asset based management Main goal is storing liquidity in the form of liquid assets. Less risky and often used by smaller institutions Costs Opportunity cost of foregone earnings if sold Transaction Costs Weakened Balance Sheet as it’s a substitution to a high yield long term asset Liability based management - Raising funds via borrowing if needed Only borrow if funds are needed Volume and composition of asset portfolio is unchanged Can always attract funds (by increasing rate)
- 20. Statement of StructuralLiquidity 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
- 21. Statement of StructuralLiquidity 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.
- 22. An Example ofStructural Liquidity Statement 1-14 Days 15-28 Days 30 Days-3 Month 3 - 6 Months 6 Months - 1Year 1 - 3 Years Years 3 - 5 Years Over 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 int 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 (100.00) (100.00) 100.00 (50.00) (150.00) 50.00 (50.00) 300.00 - Cumulative Gap (100.00) (200.00) (100.00) (150.00) (300.00) (250.00) (300.00) - -
- 23. 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.
- 24. Currency Risk Theincreased 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.
- 25. Interest Rate Risk Interest Rate risk is the exposure of a bank’s financial conditions to adverse movements of interest rates which 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 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.
- 26. Sources of InterestRate Risk Interest Rate Risk Basis Gap/ Re- pricing Yield (Price & Reinvestment) Options
- 27. Gap /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 i.e. interest rate of different assets and liabilities may change in different magnitudes 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. LT securities are more sensitive to Interest risk. Prices of bonds are inversely related to Yield and Reinvestment of coupon during low rate fall may happen at lower rate 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. Sources of Interest Rate Risk
- 28. Risk Measurement Techniques Varioustechniques for measuring exposure of banks to interest rate risks. To mitigate interest rate risk, the structure of the balance sheet has to be managed in such a way that the effect on assets of any movement in Interest rates remains highly correlated with its effect on Liabilities, even in Volatile interest rate environments. Maturity Gap Analysis (IRS) Duration Simulation Value at Risk
- 29. Maturity Gap Method(IRS) 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
- 30. What Determines RateSensitivity? An asset or liability is considered rate sensitivity if during the time interval: It matures It represents and interim, or partial, principal payment It can be re-priced The interest rate applied to the outstanding principal changes contractually during the interval The outstanding principal can be re-priced when some base rate of index changes and management expects the base rate / index to change during the interval
- 31. Interest-Sensitive Assets &Liabilities Interest Sensitive Assets Short-Term Securities Issued by the Government and Private Borrowers Short-Term Loans Made by the Bank to Borrowing Customers Variable-Rate Loans Made by the Bank to Borrowing Customers Interest Sensitive Liabilities Borrowings from Money Markets Short-Term Savings Accounts Money-Market Deposits Variable-Rate Deposits
- 32. Example A bankmakes a $10,000 four-year car loan to a customer at fixed rate of 8.5%. The bank initially funds the car loan with a one-year $10,000 CD at a cost of 4.5%. The bank’s initial spread is 4%. What is the bank’s one year gap? RSA1yr = $0 RSL1yr = $10,000 GAP1yr = $0 - $10,000 = -$10,000 The bank’s one year funding GAP is -10,000 If interest rates rise (fall) in 1 year, the bank’s margin will fall (rise) 4 year Car Loan 8.50% 1 Year CD 4.50% 4.00%
- 33. Gap Analysis Simplematurity/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.
- 34. Measuring Interest RateRisk with GAP Traditional Static GAP Analysis GAPt = RSAt – RSLt RSAt (Rate Sensitive Assets) Those assets that will mature or reprice in a given time period (t) RSLt (Rate Sensitive Liabilities) Those liabilities that will mature or reprice in a given time period (t)
- 35. It isthe weighted average time to maturity of all the preset values of cash flows It basically refers to the average life of the asset or the liability Duration Measures the sensitivity of the value of a series of cash flows to changes in interest rates. It is approximately the average point at which the projected cash flows occur. For example, if a portfolio of assets has a duration of 4, a 1% increase in interest rates will cause a 4% decrease in its value 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. Duration Analysis
- 36. Simulation Basically simulationmodels 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
- 37. Value at Risk(VaR) 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
- 38.