REPORT on Asset Liability Management_Reshma_Fernandes

8/6/2019 REPORT on Asset Liability Management_Reshma_Fernandes

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Asset Liability Management

Certificate

This is to certify that Miss. Reshma Fernandes student of N.L.Dalmia Institute of Management Studies & Research hassuccessfully carried out the project on Asset LiabilityManagement under my supervision & guidance as partialfulfillment of the requirements of PGDBM course, 2007-09.

Prof. V.S Date Prof. P.L.Arya

(Project Guide) (Director,NLDIMSR)

Acknowledgement

My special thanks to all the professors for imparting usefulinformation on the project. It gives me a sense of great pride toacknowledge the fact that working on this project has addedvalue to my learning process.

N.L.Dalmia Institute of Management Studies and Research 2


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I also extend my gratitude to Prof. Vinayak Date, our CourseCoordinator, for providing the necessary guidance and support,during the preparation of the project.

Also I would like to take this opportunity to thank all the staff ofN.L. Dalmia Institute of Management Studies and Research forproviding the necessary infrastructure and facilities for helping totake the project to fruition.

Reshma Fernandes

(PGDBM Finance, 2007-09)

Contents

Asset - Liability Management concept and its Emergence Asset - Liability Management in Banks Three requirements to implement ALM in Banks

Components of Assets & Liabilities Purpose and Objectives of Asset - Liability Management

Advantages of Asset - Liability Management Risk Categories

Risk Measurement Techniques Pre - Conditions for the Success of ALM in Banks Asset - Liability Management Strategies for Correcting

Mismatch



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Information Technology and Asset - Liability Management inthe Indian context

Emerging Issues in the Indian context

Conclusion

Bibliography

Asset - Liability Management concept and itsEmergence:

In banking, asset liability management is the practice ofmanaging risks that arise due to mismatches between the assetsand liabilities (debts and assets) of the bank.

Banks face several risks such as the liquidity risk, interest raterisk, credit risk and operational risk. Asset Liability management(ALM) is a strategic management tool to manage interest rate riskand liquidity risk faced by banks, other financial servicescompanies and corporations.

Banks manage the risks of Asset liability mismatch by matchingthe assets and liabilities according to the maturity pattern or thematching the duration, by hedging and by securitization. Theearly origins of asset and liability management date to the highinterest rate periods of 1975-6 and the late 1970s and early1980s in the United States.

Modern risk management now takes place from an integrated

approach to enterprise risk management that reflects the factthat interest rate risk, credit risk, market risk, and liquidity riskare all interrelated.

Asset-liability management (ALM) is a term whose meaning hasevolved. It is used in slightly different ways in different contexts.ALM was pioneered by financial institutions, but corporations now



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also apply ALM techniques. This article describes ALM as ageneral concept, starting with more traditional usage.

Traditionally, banks and insurance companies used accrualaccounting for essentially all their assets and liabilities. Theywould take on liabilities, such as deposits, life insurance policiesor annuities. They would invest the proceeds from these liabilitiesin assets such as loans, bonds or real estate. All assets andliabilities were held at book value. Doing so disguised possiblerisks arising from how the assets and liabilities were structured.

Consider a bank that borrows USD 100MM at 3.00% for a yearand lends the same money at 3.20% to a highly-rated borrowerfor 5 years. For simplicity, assume interest rates are annuallycompounded and all interest accumulates to the maturity of the

respective obligations. The net transaction appears profitablethe bank is earning a 20 basis point spreadbut it entailsconsiderable risk. At the end of a year, the bank will have to findnew financing for the loan, which will have 4 more years before itmatures. If interest rates have risen, the bank may have to pay ahigher rate of interest on the new financing than the fixed 3.20 itis earning on its loan.

Suppose, at the end of a year, an applicable 4-year interest rateis 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. Accrualaccounting does not recognize the problem. The book value ofthe loan (the bank's asset) is:

100MM (1.032) = 103.2MM.

The book value of the financing (the bank's liability) is:

100MM (1.030) = 103.0MM.

Based upon accrual accounting, the bank earned USD 200,000 inthe first year.

Market value accounting recognizes the bank's predicament. Therespective market values of the bank's asset and liability are:



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100MM (1.030) = 103.0MM.

From a market-value accounting standpoint, the bank has lostUSD 10.28MM.

So which result offers a better portrayal of the bank's situation,the accrual accounting profit or the market-value accountingloss? The bank is in trouble, and the market-value loss reflectsthis. Ultimately, accrual accounting will recognize a similar loss.

The bank will have to secure financing for the loan at the newhigher rate, so it will accrue the as-yet unrecognized loss over the

4 remaining years of the position.

The problem in this example was caused by a mismatch betweenassets and liabilities. Prior to the 1970's, such mismatches tendednot to be a significant problem. Interest rates in developedcountries experienced only modest fluctuations, so losses due toasset-liability mismatches were small or trivial. Many firmsintentionally mismatched their balance sheets. Because yieldcurves were generally upward sloping, banks could earn a spreadby borrowing short and lending long.

Things started to change in the 1970s, which ushered in a periodof volatile interest rates that continued into the early 1980s. USregulation, which had capped the interest rates that banks couldpay depositors, was abandoned to stem a migration overseas ofthe market for USD deposits. Managers of many firms, who wereaccustomed to thinking in terms of accrual accounting, were slowto recognize the emerging risk. Some firms suffered staggeringlosses. Because the firms used accrual accounting, the result wasnot so much bankruptcies as crippled balance sheets. Firms

gradually accrued the losses over the subsequent 5 or 10 years.One example is the US mutual life insurance company theEquitable. During the early 1980s, the USD yield curve wasinverted, with short-term interest rates spiking into the highteens. The Equitable sold a number of long-term guaranteedinterest contracts (GICs) guaranteeing rates of around 16% forperiods up to 10 years. During this period, GICs were routinely for



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principal of USD 100MM or more. Equitable invested the assetsshort-term to earn the high interest rates guaranteed on thecontracts. Short-term interest rates soon came down. When theEquitable had to reinvest, it couldn't get nearly the interest ratesit was paying on the GICs. The firm was crippled. Eventually, ithad to demutualize and was acquired by the Axa Group.

Increasingly, managers of financial firms focused on asset-liabilityrisk. The problem was not that the value of assets might fall orthat the value of liabilities might rise. It was that capital might bedepleted by narrowing of the difference between assets andliabilitiesthat the values of assets and liabilities might fail tomove in tandem. Asset-liability risk is a leveraged form of risk.

The capital of most financial institutions is small relative to thefirm's assets or liabilities, so small percentage changes in assetsor liabilities can translate into large percentage changes incapital.

Exhibit 1 illustrates the evolution over time of a hypotheticalcompany's assets and liabilities. Over the period shown, theassets and liabilities change only slightly, but those slightchanges dramatically reduce the company's capital (which, forthe purpose of this example, is defined as the difference betweenassets and liabilities). In Exhibit 1, the capital falls by over 50%, adevelopment that would threaten almost any institution.

Example: Asset-Liability Risk

Exhibit 1

Asset-liability risk is leveraged by the fact that the values ofassets and liabilities each tend to be greater than the value of



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capital. In this example, modest fluctuations in values of assetsand liabilities result in a 50% reduction in capital.

Accrual accounting could disguise the problem by deferringlosses into the future, but it could not solve the problem. Firmsresponded by forming asset-liability management (ALM)departments to assess asset-liability risk. They established ALMcommittees comprised of senior managers to address the risk.

Techniques for assessing asset-liability risk came to include gapanalysis and duration analysis. These facilitated techniques ofgap management and duration matching of assets and liabilities.Both approaches worked well if assets and liabilities comprisedfixed cash flows. Options, such as those embedded in mortgagesor callable debt, posed problems that gap analysis could not

address. Duration analysis could address these in theory, butimplementing sufficiently sophisticated duration measures wasproblematic. Accordingly, banks and insurance companies alsoperformed scenario analysis.

With scenario analysis, several interest rate scenarios would bespecified for the next 5 or 10 years. These might specify decliningrates, rising rates, a gradual decrease in rates followed by asudden rise, etc. Scenarios might specify the behavior of theentire yield curve, so there could be scenarios with flattening

yield curves, inverted yield curves, etc. Ten or twenty scenariosmight be specified in all.

Next, assumptions would be made about the performance ofassets and liabilities under each scenario. Assumptions mightinclude prepayment rates on mortgages or surrender rates oninsurance products. Assumptions might also be made about thefirm's performancethe rates at which new business would beacquired for various products. Based upon these assumptions,the performance of the firm's balance sheet could be projected

under each scenario. If projected performance was poor underspecific scenarios, the ALM committee might adjust assets orliabilities to address the indicated exposure. A shortcoming ofscenario analysis is the fact that it is highly dependent on thechoice of scenarios. It also requires that many assumptions bemade about how specific assets or liabilities will perform underspecific scenarios.



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In a sense, ALM was a substitute for market-value accounting in acontext of accrual accounting. It was a necessary substitutebecause many of the assets and liabilities of financial institutionscould notand still cannotbe marked to market. This spirit ofmarket-value accounting was not a complete solution. A firm canearn significant mark-to-market profits but go bankrupt due toinadequate cash flow. Some techniques of ALMsuch as durationanalysisdo not address liquidity issues at all. Others arecompatible with cash-flow analysis. With minimal modification, agap analysis can be used for cash flow analysis. Scenario analysiscan easily be used to assess liquidity risk.

Firms recognized a potential for liquidity risks to be overlooked inALM analyses. They also recognized that many of the tools usedby ALM departments could easily be applied to assess liquidityrisk. Accordingly, the assessment and management of liquidityrisk became a second function of ALM departments and ALMcommittees. Today, liquidity risk management is generallyconsidered a part of ALM.

ALM has evolved since the early 1980's. Today, financial firms areincreasingly using market-value accounting for certain businesslines. This is true of universal banks that have trading operations.For trading books, techniques of market risk managementvalue-at-risk (VaR), market risk limits, etc.are more appropriate

than techniques of ALM. In financial firms, ALM is associated withthose assets and liabilitiesthose business linesthat areaccounted for on an accrual basis. This includes bank lending anddeposit taking. It includes essentially all traditional insuranceactivities.

Techniques of ALM have also evolved. The growth of OTCderivatives markets has facilitated a variety of hedgingstrategies. A significant development has been securitization,which allows firms to directly address asset-liability risk by

removing assets or liabilities from their balance sheets. This notonly eliminates asset-liability risk; it also frees up the balancesheet for new business.

The scope of ALM activities has widened. Today, ALMdepartments are addressing (non-trading) foreign exchange risksand other risks. Also, ALM has extended to non-financial firms.



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Corporations have adopted techniques of ALM to addressinterest-rate exposures, liquidity risk and foreign exchange risk.

They are using related techniques to address commodities risks.For example, airlines' hedging of fuel prices or manufacturers'hedging of steel prices are often presented as ALM.

There are two types of ALM analysis:

Analytical: This includes liquidity and sensitivity gaps, sensitivityand parametric Value at Risk analysis

Numerical: This includes stress scenario and Value at Risk (VaR)analysis.

Asset - Liability Management in Banks:

Ever since the initiation of the process of deregulation of theIndian banking system and gradual freeing of interest rates tomarket forces, and consequent injection of a dose of competitionamong the banks, introduction of asset-liability management(ALM) in the public sector banks (PSBs) has been suggested byseveral experts. But, initiatives in this respect on the part of mostbank managements have been absent. This seems to have ledthe Reserve Bank of India to announce in its monetary and creditpolicy of October 1997 that it would issue ALM guidelines tobanks. While the guidelines are awaited, an informal check withseveral PSBs shows that none of these banks has moveddecisively to date to introduce ALM.



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One reason for this neglect appears to be a wrong notion amongbankers that their banks already practice ALM. As per thisunderstanding, ALM is a system of matching cash inflows andoutflows, and thus of liquidity management. Hence, if a bankmeets its cash reserve ratio and statutory liquidity ratiostipulations regularly without undue and frequent resort topurchased funds, it can be said to have a satisfactory system ofmanaging liquidity risks, and, hence, of ALM.

The actual concept of ALM is however much wider, and of greaterimportance to banks performance. Historically, ALM has evolvedfrom the early practice of managing liquidity on the bank's assetside, to a later shift to the liability side, termed liabilitymanagement, to a still later realization of using both the assetsas well as liabilities sides of the balance sheet to achieveoptimum resources management. But that was till the 1970s.

In the 1980s, volatility of interest rates in USA and Europe causedthe focus to broaden to include the issue of interest rate risk. ALMbegan to extend beyond the bank treasury to cover the loan anddeposit functions. The induction of credit risk into the issue ofdetermining adequacy of bank capital further enlarged the scopeof ALM in later 1980s.

In the current decade, earning a proper return of bank equity and

hence maximization of its market value has meant that ALMcovers the management of the entire balance sheet of a bank.

This implies that the bank managements are now expected totarget required profit levels and ensure minimization of risks toacceptable levels to retain the interest of investors in their banks.

This also implies that costing and pricing policies have become ofparamount importance in banks.

In the regulated banking environment in India prior to the 1990s,the equation of ALM to liquidity management by bankers could be

understood. There was no interest rate risk as the interest rateswere regulated and prescribed by the RBI. Spreads between thedeposit and lending rates were very wide (these still areconsiderable); also, these spreads were more or less uniformamong the commercial banks and were changed only by RBI.



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If a bank suffered significant losses in managing its bankingassets, the same were absorbed by the comfortably widespreads. Clearly, the bank balance sheet was not being managedby banks themselves; it was being `managed' throughprescriptions of the regulatory authority and the government.

This situation has now changed. The banks have been given alarge amount of freedom to manage their balance sheets. But theknowledge, new systems and organizational changes that arecalled for to manage it, particularly the new banking risks, arestill lagging.

The turmoil in domestic and international markets during the lastfew months and impending changes in the country's financialsystem are a grim warning to our bank managements to gear uptheir balance sheet management in a single heave. To begin with,as the RBI's monetary and credit policy of October 1997recommends, an adequate system of ALM to incorporatecomprehensive risk management should be introduced in thePSBs. It is suggested that the PSBs should introduce ALM whichwould focus on liquidity management, interest rate riskmanagement and spread management.

Three requirements to implement ALM in Banks:



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(a) Developing a better understanding of ALM concepts

(b) Introducing an ALM information system

Information is the key to the ALM process. Considering the largenetwork of branches and the lack of an adequate system tocollect information required for ALM which analyses informationon the basis of residual maturity and behavioral pattern it willtake time for banks in the present state to get the requisiteinformation. The problem of ALM needs to be addressed byfollowing an ABC approach i.e. analyzing the behavior of assetand liability products in the top branches accounting forsignificant business and then making rational assumptions aboutthe way in which assets and liabilities would behave in otherbranches. In respect of foreign exchange, investment portfolio

and money market operations, in view of the centralized natureof the functions, it would be much easier to collect reliableinformation. The data and assumptions can then be refined overtime as the bank management gain experience of conductingbusiness within an ALM framework. The spread ofcomputerization will also help banks in accessing data.

(c) Setting up ALM decision-making processes (ALMCommittee/ALCO)

The Board should have overall responsibility for management ofrisks and should decide the risk management policy of the bankand set limits for liquidity, interest rate, foreign exchange andequity price risks.

The Asset - Liability Committee (ALCO) consisting of the bank'ssenior management including CEO should be responsible forensuring adherence to the limits set by the Board as well as for

deciding the business strategy of the bank (on the assets andliabilities sides) in line with the bank's budget and decided riskmanagement objectives.

The ALM desk consisting of operating staff should be responsiblefor analyzing, monitoring and reporting the risk profiles to theALCO. The staff should also prepare forecasts (simulations)showing the effects of various possible changes in market



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conditions related to the balance sheet and recommend theaction needed to adhere to bank's internal limits.

The ALCO is a decision making unit responsible for balance sheetplanning from risk - return perspective including the strategicmanagement of interest rate and liquidity risks. Each bank willhave to decide on the role of its ALCO, its responsibility as alsothe decisions to be taken by it. The business and riskmanagement strategy of the bank should ensure that the bankoperates within the limits / parameters set by the Board.

The business issues that an ALCO would consider, inter alia, willinclude product pricing for both deposits and advances, desiredmaturity profile of the incremental assets and liabilities, etc. Inaddition to monitoring the risk levels of the bank, the ALCO

should review the results of and progress in implementation ofthe decisions made in the previous meetings. The ALCO wouldalso articulate the current interest rate view of the bank and baseits decisions for future business strategy on this view.

In respect of the funding policy, for instance, its responsibilitywould be to decide on source and mix of liabilities or sale ofassets. Towards this end, it will have to develop a view on future

direction of interest rate movements and decide on a funding mixbetween fixed vs floating rate funds, wholesale vs retail deposits,money market vs capital market funding, domestic vs foreigncurrency funding, etc. Individual banks will have to decide thefrequency for holding their ALCO meetings.

Composition of ALCO:

The size (number of members) of ALCO would depend on the sizeof each institution, business mix and organizational complexity.

To ensure commitment of the Top Management, the CEO/CMD orED should head the Committee. The Chiefs of Investment, Credit,Funds Management / Treasury (Forex and domestic),International Banking and Economic Research can be members ofthe Committee. In addition the Head of the Information

Technology Division should also be an invitee for building up of



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MIS and related computerization. Some banks may even havesub-committees.

Committee of Directors:

Banks should also constitute a professional Managerial andSupervisory Committee consisting of three to four directors whichwill oversee the implementation of the system and review itsfunctioning periodically.

The scope of ALM function can be described as follows:

Liquidity risk management

Management of market risks (including Interest RateRisk) Funding and capital planning Profit planning and growth projection

Trading risk management

However the above mentioned three requirements to implementALM are already met by the new private sector banks, forexample. These banks have their balance sheets available at theclose of every day. Repeated changes in interest rates by themduring the last 3 months to manage interest rate risk and theirmaturity mismatches are based on data provided by their MIS. Incontrast, loan and deposit pricing by PSBs is based partly onhunches, partly on estimates of internal macro data, and partlyon their competitors' rates. Hence, PSBs would first and foremostneed to focus son putting in place an ALM which would providethe necessary framework to define, measure, monitor, modifyand manage interest rate risk. This is the need of the hour.



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Components of Assets & Liabilities in Banks BalanceSheet and their Management:

Banks Liabilities:

The sources of funds for the lending and investment activitiesconstitute liabilities side of balance sheet i.e.

I) 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.

II) Reserves and Surplus

Components under this head include:

- Statutory Reserves- Capital Reserves- Investment Fluctuation Reserve- Revenue and Other Reserves- Balance in Profit and Loss Account

III) Deposits

This is the main source of banks funds. The deposits areclassified as deposits payable on demand and time. Theyare reflected in balance sheet as under:

- Demand Deposits- Savings Bank Deposits- Term Deposits



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IV) Borrowings

It includes Refinance / Borrowings from RBI, Inter-bank & otherinstitutions

Borrowings in India

i) Reserve Bank of Indiaii) Other Banksiii) Other Institutions & Agencies

Borrowings outside India

V) Other Liabilities and Provisions

It includes:

i) Bills Payableii) Inter Office Adjustments (Net)iii) Interest Accruediv) Unsecured Redeemable Bonds (Subordinated Debt

for Tier-II Capital)v) Others (including provisions)

VI) Contingent Liabilities

Banks obligations under Letter of Credits, Guarantees, andAcceptances on behalf of constituents and Bills accepted bythe bank are reflected under this heads.

Banks Assets:

The funds mobilized by bank through various sources are:

I) Cash and Bank balances with Reserve Bank ofIndia.

- Cash in hand (including foreign currency notes)- Balances with Reserve Bank of India (In Current Accounts

and In Other Accounts)

II) Balances with banks and money at call and shortnotice.



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In India

Balances with Banks

a) In Current Accountsb) In Other Deposit Accounts

Money at Call and Short Notice

a) With Banksb) With Other Institutions

Outside India

a) In Current Accounts

b) In Other Deposit Accounts

c) Money at Call & Short Notice

III) Investments

It is a major asset item in the banks balance sheet. Reflectedunder 6 buckets as under:

Investments in India in:

i) Government Securitiesii) Other approved Securitiesiii) Sharesiv) Debentures and Bondsv) Subsidiaries and Sponsored Institutionsvi) Others (UTI Shares, Commercial Papers, COD & Mutual

Fund Units etc.)

Investments outside India in:

Subsidiaries and/or Associates abroad

IV) Advances

A. i) Bills Purchased and Discounted



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ii) Cash Credits, Overdrafts & Loans repayable on demand

iii) Term Loans

B. Particulars of Advances:

i) Secured by tangible assets (including advances againstBook Debts)

ii) Covered by Bank/ Government Guarantees

iii) Unsecured

V) Fixed Assets

I. Premises

II. Other Fixed Assets (Including furniture and fixtures)

VI) Other Assets.

- 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



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Purpose and Objectives of Asset - LiabilityManagement:

1. Review the interest rate structure and compare the same tothe interest/product pricing of both assets and liabilities.

2. Examine the loan and investment portfolios in the light of theforeign exchange risk and liquidity risk that might arise.

3. Examine the credit risk and contingency risk that may originateeither due to rate fluctuations or otherwise and assess the qualityof assets.

4. Reviews the actual performance against the projections madeand analyzes the reasons for any effect on spreads.

5. Aim is to stabilize the short-term profits, long-term earningsand long-term substance of the bank. The parameters that areselected for the purpose of stabilizing asset liability managementof banks are:

Net Interest Income (NII)

Net Interest Margin (NIM)

Economic Equity Ratio

Net Interest Income = Interest Income - Interest Expenses.

Net Interest Margin = Net Interest Income/Average Total Assets

Economic Equity Ratio- The ratio of the shareholders funds to thetotal assets measures the shifts in the ratio of owned funds tototal funds. The fact assesses the sustenance capacity of thebank

Advantages of Asset - Liability Management:



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Leverages the Powerful Cash Flow Engine to EnhanceFlexibility of Analysis:

The powerful Cash Flow Engine (CFE) of Asset LiabilityManagement application shreds accounts level data into itsconstituent cash flows. Given the end of period balances and theschedule terms, the CFE can generate multiple cash flows asrequired for different analyses.

Enables Factual and Consistent Risk Measurement:

Asset Liability Management application supports both Earningsand Economic Value perspectives in a single framework. Using asingle download of information from the source system along withsome set-up information, the Asset Liability Management

application generates all three AL perspectives Liquidity,Earnings, and Economic Value, thus ensuring factual andconsistent risk measurement. Analyses use the same data set,ensuring consistency.

Facilitates Multi-Currency Analyses:

Asset Liability Management application tags individual accountswith their respective currencies, enabling users to exploremismatches across currencies, both time band wise and

cumulatively. The currency conversion engine works on the three-currency framework through the natural, local, and reportingcurrency.

Robust What if Engine Enables the Creation andEvaluation of Multiple Scenarios:

Asset Liability Management application enables the risk

managers to simulate multiple scenarios to evaluate the potentialimpact on the Balance Sheet due to possible changes in the keydrivers of business be it New Business Volumes, Interest Rates,Currency Rates, or change in portfolio composition throughswitches. Designed for ease-of-use, Asset Liability Managementapplication works off metadata and allows end-users to explorescenarios by changing variables individually or in combinationsacross product, branch, and benchmark dimensions.



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Solution Design Helps Adopt Regulatory Frameworks:

Risk professionals need solutions that simplify adoption of, andchecking conformance to, regulatory norms. Asset LiabilityManagement application design has drawn from standards likethe Basel Norms (Principles of Interest rate risk in 2001).

An illustrative list of features includes:

Supports both earnings and economic value perspectives

CFE granularity enables:

a. Aggregation to any level

b. Computing of Cash Flow duration

Enables Sensitivity Analysis sensitivity of accrued interest,interest flows, time weighted flows, etc.

Interest Rate Shocking both Standard and Percentileapproaches

What-If Scenario analyses

Leverages Multi-dimensional Analyses:

ALM professionals of various roles need different views anddetails of business situations. Asset Liability Managementapplication leverages multi-dimensional analyses to allow rapidnavigation through relevant data, and quickly provides multipleinternally consistent views of specific data sets, enabling adeeper and quicker grasp of risk numbers. Illustrative dimensionsare Rate Sensitivity, Time, Time-Bands, Organization or BusinessUnit, Currency, Interest Type, and Product.

Accurately Identifies Mismatches and Locates RiskConcentrations:

Identifying mismatches and the risk concentration points thatlead to the mismatches is critical to risk management. AssetLiability Management application enables the locating ofmismatches both On Balance Sheet and Off Balance Sheet, as



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well as the identification of concentration points by drilling downon business lines, product, and currency. Time dimension enablestrend analysis across time. All these capabilities facilitate a moreinformed risk response.

Categories of Risk:

Credit risk:

The risk of counter party failure in meeting the paymentobligation on the specific date is known as credit risk. Credit riskmanagement is an important challenge for financial institutionsand failure on this front may lead to failure of banks. The recentfailure of many Japanese banks and failure of savings and loanassociations 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 thecounter party, and the ability to pay need not necessarily gotogether.

The other important issue is contract enforcement in countrieslike India. Legal reforms are very critical in order to have timelycontract enforcement. Delays and loopholes in the legal systemsignificantly affect the ability of the lender to enforce thecontract. The legal system and its processes are notorious fordelays showing scant regard for time and money that is the basis

of sound functioning of the market system. Over two millioncases are pending in 18 High Courts alone and more than200,000 cases are pending in the Supreme Court for admission,interim relief or final hearing.

This is not the full story. Since thousands of cases are pending inthe lower courts, legal experts suggest that the average time



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taken by Indian courts for deciding a civil I case is around 7 to 10years (Shah, 1998), if not more. The right of the lessor torepossess the leased asset, in case of default by the lessee wasnot very clear until the Bombay High Court ruled (and theSupreme Court upheld) that the lessor has a right to so repossess(in the case of Twentieth Century Finance Corporation vs. SLMManeklal Industries Ltd.). Hence the required rate of return due tofeeble contract enforcement mechanisms becomes larger incountries like India. Therefore, a good portion of non-performingassets of commercial banks in India is related to deficiencies incontract enforcement mechanisms. Credit risk is also linked tomarket risk variables. In a highly volatile interest rateenvironment, loan defaults could increase thereby affecting creditquality.

The expansion of banking sector was phenomenal during the1970s and 1980s. Mobilization of deposits was one of the majorobjectives of commercial banks. To that extent, performanceappraisal and incentive system within the banking sector wasmore based on deposit mobilization and achievement of deposittargets rather than on lending practices and credit riskassessment mechanisms.

Hence, it is important that the banks reorient their approach interms of Reformulating performance appraisal systems, which

focus more on lending practices and credit risk assessments inthe changed scenario. Credit rating to some extent facilitates theunderstanding of credit risk. But the quality of financialinformation provided by Corporates leaves much to be desired. Inthe case of the unincorporated sector, namely a partnership andproprietorship firm, the task of credit risk assessment is morecomplicated because of lack of reliable and continuous financialinformation.

Capital risk:

Capital Risk means the risk an investor faces that he or she maylose all or part of the principal amount invested. It also means therisk a company faces that it may lose value on its capital. Thecapital of a company can include equipment, factories and liquidsecurities.



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For example, when someone invests $10,000 into the stockmarket, he or she faces a capital risk on the $10,000 invested.Similarly, if a company does not insure the value of some of itsassets, it will face capital risk from such things as fire, flood andtheft.

One of the sound aspects of the banking practice is themaintenance of adequate capital on a continuous basis. There areattempts to bring in global norms in this field in order to bring incommonality and standardization in international practices.Capital adequacy also focuses on the weighted average risk oflending and to that extent; banks are in a position to realign theirportfolios between more risky and less risky assets.

Market risk:

Market Risk is common to an entire class of assets or liabilities.The value of investments may decline over a given time periodsimply because of economic changes or other events that impactlarge portions of the market. Asset allocation and diversificationcan protect against market risk because different portions of themarket tend to underperform at different times. It is also calledsystematic risk.

Market risk is related to the financial condition, which results from

adverse movement in market prices. This will be morepronounced when financial information has to be provided on amarked-to-market basis since significant fluctuations in assetholdings could adversely affect the balance sheet of banks.

In the Indian context, the problem is accentuated because manyfinancial institutions acquire bonds and hold it till maturity. Whenthere is a significant increase in the term structure of interestrates, or violent fluctuations in the rate structure, one findssubstantial erosion of the value of the securities held.

Interest rate risk:

Interest risk is the change in prices of bonds that could occur as aresult of change: n interest rates. It also considers change inimpact 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



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deposits differed from those for which they fixed on assets, banksincurred interest rate risk i.e., they stood to make gains or losseswith every change in the level of interest rates. As long aschanges in rates were predictable both in magnitude and intiming over the business cycle, interest rate risk was not seen astoo serious, but as rates of interest became more volatile, therewas felt need for explicit means of monitoring and controllinginterest gaps.

In most OECD countries (Harrington, 1987), the situation was nodifferent from that which prevailed in domestic banking. The termto maturity of a bond provides clues to the fluctuations in theprice of the bond since it is fairly well-known that longer maturitybonds have greater fluctuations for a given change in the interestrates compared to shorter maturity bonds. In other wordscommercial banks, which are holding large proportions of longermaturity bonds, will face more price reduction when the interestrates go up. Between 1970s and the early part of 1990s, therehas been a substantial change in the maturity structure of bondsheld by commercial banks.

During 1961, 34% of the central government securities had amaturity of less than 5 years and 27% more than 10 years. But in1991, only 9% of the securities had a maturity of less than 5years, while 86% were more than 10 years (Vaidyanathan, 1995).

During 1992, when the reform process started and efforts takento move away from the administered interest rate mechanism tomarket determined rates, financial institutions were affectedbecause longer maturity instruments have greater fluctuationsfor a given change in the interest rate structure. This becomes allthe grimmer when interest rates move up because the prices ofthe holding came down significantly and in a marked-to-marketsituation, severely affect bottom lines of banks.

Another associated issue is related to the coupon rate of the

bonds. Throughout the 1970s and 1980s, the government wasborrowing from banks using the statutory obligation route atartificially low interest rates ranging between 4.5% to 8% (TheWorld Bank, 1995). The smaller the coupon rate of bonds, largeris the fluctuation associated with a change in interest ratestructure. Because of artificially fixed low coupon rates,



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commercial banks faced adverse situations when the interest ratestructure was liberalized to align with market rates.

Therefore, the banking industry in India has substantially moreissues associated with interest rate risk, which is due tocircumstances outside its control. This poses extra challenges to

the banking sector and to that extent; they have to adoptinnovative and sophisticated techniques to meet some of thesechallenges. There are certain measures available to measureinterest rate risk. These include:

Maturity:

Since it takes into account only the timing of the final principalpayment, maturity is considered as an approximate measure ofrisk and in a sense does not quantify risk. Longer maturity bondsare generally subject to more interest rate risk than shortermaturity bonds.

Duration:

Duration is the weighted average time of all cash flows, withweights being the present values of cash flows. Duration canagain be used to determine the sensitivity of prices to changes ininterest rates. It represents the percentage change in value inresponse to changes in interest rates.

Dollar duration:

Dollar duration represents the actual dollar change in the marketvalue of a holding of the bond in response to a percentagechange in rates.

Convexity:



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Because of a change in market rates and because of passage oftime, duration may not remain constant. With each successivebasis point movement downward, bond prices increase at anincreasing rate. Similarly if rates increase, the rate of decline ofbond prices declines. This property is called convexity.

In the Indian context, banks in the past were primarily concernedabout adhering to statutory liquidity ratio norms and to thatextent they were acquiring government securities and holding ittill maturity. But in the changed situation, namely moving awayfrom administered interest rate structure to market determinedrates, it becomes important for banks to equip themselves withsome of these techniques, in order to immunize banks againstinterest rate risk.

Liquidity risk:

Liquidity risk affects many Indian institutions. It is the potentialinability to generate adequate cash to cope with a decline indeposits or increase in assets. To a large extent, it is an outcomeof the mismatch in the maturity patterns of assets and liabilities.First, the proportion of central government securities with longermaturities in the Indian bond market, significantly increasingduring the 1970s and 1980s, affected the banking systembecause longer maturity securities have greater volatility for a

given change in interest rate structure. This problem getsaccentuated in the context of change in the main liabilitystructure of the banks, namely the maturity period for termdeposits.

For instance in 1986, nearly 50% of term deposits had a maturityperiod of more than 5 years and only 20%, less than 2 years forall commercial banks. But in 1992, only 17% of term depositswere more than 5 years whereas 38% were less than 2 years(Vaidyanathan, 1995).

In such a situation, we find banks facing significant problems interms of mismatch between average life of bonds and maturitypattern of term deposits. The Ministry of Finance as well as theRBI has taken steps to reduce the average maturity period ofbonds held by commercial banks in the last few years. In otherwords, newer instruments are being floated with shorter



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maturities accompanied by roll over of earlier instruments withshorter maturities. In order to meet short-term liability payments,institutions have to maintain certain levels of cash at all points oftime. Thus managing cash flows becomes crucial. Institutionscould access low cost funding or could have assets that havesufficient short-term cash flows. Hence, banking institutions needto strike a reasonable trade off between being excessively liquidand relatively illiquid.

The recent failure of many non-banking financial companies canbe ascribed to mismatch between asset-liability maturities, sincemany of them have invested in real estate type of assets withshort-term borrowings. Particularly in a declining real estatemarket, it becomes difficult for non-banking financial companiesto exit and meet obligations of lenders. In such a context,liquidity becomes a much more significant variable even at thecost of forgoing some profitability.

Types of Liquidity Risk:

Liquidity Exposure can stem from both internally and externally.

External liquidity risks can be geographic, systemic or instrumentspecific.

Internal liquidity risk relates largely to perceptions of aninstitution in its various markets: local, regional, national orinternational

Funding Risk - Need to replace net outflows due to unanticipatedwithdrawals/ non-renewal

Time Risk - Need to compensate for non-receipt of expectedinflows of funds

Call Risk - Crystallization of contingent liability

Yield Curve Risk:

Currently yield curve risk is limited in Indian Banks as mostly the

assets and liabilities in Indian banking system are either at fixedrate or at floating rate linked to internal benchmarks.

For example, through most of the term loans and cash creditloans in banking system are at floating rate linked to internal PLRof banks, the degree to which they respond to changes inexternal benchmark rates is a matter of debate. Further, the



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relevance of benchmark PLR is itself questionable when banks arelending at sub-PLR rates.

Currency Risk:

Floating exchange rate arrangement has brought in its wakepronounced volatility adding a new dimension to the risk profileof banks' balance sheets. The increased capital flows across freeeconomies following deregulation have contributed to increase inthe volume of transactions. Large cross border flows togetherwith the volatility has rendered the banks' balance sheetsvulnerable to exchange rate movements.

Dealing in different currencies brings opportunities as also risks. Ifthe liabilities in one currency exceed the level of assets in the

same currency, then the currency mismatch can add value orerode value depending upon the currency movements. Thesimplest way to avoid currency risk is to ensure that mismatches,if any, are reduced to zero or near zero. Banks undertakeoperations in foreign exchange like accepting deposits, makingloans and advances and quoting prices for foreign exchangetransactions. Irrespective of the strategies adopted, it may not bepossible to eliminate currency mismatches altogether. Besides,some of the institutions may take proprietary trading positions asa conscious business strategy.

Managing Currency Risk is one more dimension of Asset- LiabilityManagement. Mismatched currency position besides exposing thebalance sheet to movements in exchange rate also exposes it tocountry risk and settlement risk. Ever since the RBI (ExchangeControl Department) introduced the concept of end of the daynear square position in 1978, banks have been setting upovernight limits and selectively undertaking active day timetrading. Following the introduction of "Guidelines for InternalControl over Foreign Exchange Business" in 1981, maturity

mismatches (gaps) are also subject to control. Following therecommendations of Expert Group on Foreign Exchange Marketsin India (Sodhani Committee) the calculation of exchange positionhas been redefined and banks have been given the discretion toset up overnight limits linked to maintenance of additional Tier Icapital to the extent of 5 per cent of open position limit.



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Presently, the banks are also free to set gap limits with RBI'sapproval but are required to adopt Value at Risk (VaR) approachto measure the risk associated with forward exposures. Thus theopen position limits together with the gap limits form the riskmanagement approach to Forex operations. For monitoring suchrisks banks should follow the instructions contained in CircularA.D (M. A. Series) No.52 dated December 27, 1997 issued by theExchange Control Department.

Basis Risk:

Basis risk arises due to changes in market rates on differentfinancial instruments by varying degree. The risk that the interestrate of different assets, liabilities and off-balance sheet itemsmay change in different magnitudes is termed as basis risk.

The degree of basis risk is fairly high in respect of banks thatcreate composite assets out of composite liabilities. For example,a bank may be funding floating rate loans linked to its BenchmarkPrime Lending Rate (BPLR) through composite liabilities of variousmaturities. The rates on these liabilities may change by differentdegrees whereas the bank may not be able to change its BPLR bysame degree. This may result NII of the bank to shrink in a risinginterest rate scenario.

Embedded Option Risk:

Embedded option means possibility of alteration of cash flows tothe disadvantage of a bank. Traditionally banks have offeredproducts with embedded options. The depositors enjoy freedomto close their deposits at any time by paying penalty. Similarly,there are embedded options with loan products such as cashcredit, demand loans and term loans.

Banks are experiencing embedded option even in stable interest

rate environments due to stiff competition. Pre-payments in homeloans are regular phenomenon. However, in volatile interest ratescenario, the degree of usage of embedded option goes up.Banks statistically estimate the extent of embedded options to beexercised by customers and incorporate them liquidity andinterest rate risk models. The pricing of such risks into depositand loan products has also to happen. Though Reserve Bank of



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India has permitted banks to deny premature closures in case oflarge deposits, they are currently not doing so due to fear oflosing business.

Price Risk:

Banks are required to mark to market their investment portfolioin held for trading and available for sale category. In the financialmarkets, prices of instruments and yields are inversely related.During last three years prior to March 2004, due to slow creditpick up, a large number of banks had invested in governmentsecurities more than regulatory requirements.

As per Reserve Bank of Indias guidelines banks may classify theirinvestments into three categories viz. a) Held for Trading (HFT) b)

Available for Sale (AFS) and c) Held till Maturity (HTM). Whilesecurities in HFT and AFS categories are required to be marked tomarked, the securities in HTM are not. As interest rates declined,banks made huge treasury gains in their investment portfolio.However, due to rise in yields many banks reported treasurylosses in December quarter 2004. The losses would have beenhigher, had RBI not permitted banks to shift a portion of theirsecurities to Held to Maturity class. However, notwithstandingthis accounting treatment, the rising interest rates will result ineconomic loss of bonds held in held till maturity category.

Operational risk:

Operational risk is the risk of loss resulting from inadequate orfailed internal processes, people and system or from externalevents. Operational risk is associated with human error, system

failures and inadequate procedures and controls. It is the risk ofloss arising from the potential that inadequate informationsystem; technology failures, breaches in internal controls, fraud,unforeseen catastrophes, or other operational problems mayresult in unexpected losses or reputation problems. Operationalrisk exists in all products and business activities.



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Operational risk event types that have the potential to result insubstantial losses includes Internal fraud, External fraud,employment practices and workplace safety, clients, productsand business practices, business disruption and system failures,damage to physical assets, and finally execution, delivery andprocess management.

The objective of operational risk management is the same as forcredit, market and liquidity risks that is to find out the extent ofthe financial institutions operational risk exposure; to understandwhat drives it, to allocate capital against it and identify trendsinternally and externally that would help predicting it. Themanagement of specific operational risks is not a new practice; ithas always been important for banks to try to prevent fraud,maintain the integrity of internal controls, and reduce errors intransactions processing, and so on. However, what is relativelynew is the view of operational risk management as acomprehensive practice comparable to the management of creditand market risks in principles. Failure to understand and manageoperational risk, which is present in virtually all bankingtransactions and activities, may greatly increase the likelihoodthat some risks will go unrecognized and uncontrolled.

Operational Risk Management Principles:

There are 6 fundamental principles that all institutions, regardlessof their size or complexity, should address in their approach tooperational risk management.

a) Ultimate accountability for operational risk management restswith the board, and the level of risk that the organization accepts,together with the basis for managing those risks, is driven fromthe top down by those charged with overall responsibility forrunning the business.

b) The board and executive management should ensure thatthere is an effective, integrated operational risk managementframework. This should incorporate a clearly definedorganizational structure, with defined roles and responsibilitiesfor all aspects of operational risk management/monitoring andappropriate tools that support the identification, assessment,control and reporting of key risks.



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c) Board and executive management should recognize,understand and have defined all categories of operational riskapplicable to the institution. Furthermore, they should ensure thattheir operational risk management framework adequately coversall of these categories of operational risk, including those that donot readily lend themselves to measurement.

d) Operational risk policies and procedures that clearly define theway in which all aspects of operational risk are managed shouldbe documented Managing Operational risk and communicated.

These operational risk management policies and proceduresshould be aligned to the overall business strategy and shouldsupport the continuous improvement of risk management.

e) All business and support functions should be an integral part of

the overall operational risk management framework in order toenable the institution to manage effectively the key operationalrisks facing the institution.

f) Line management should establish processes for theidentification, assessment, mitigation, monitoring and reportingof operational risks that are appropriate to the needs of theinstitution, easy to implement, operate consistently over time andsupport an organizational view of operational risks and materialfailures.

Reinvestment Risk:

The risk resulting from the fact that interest or dividends earnedfrom an investment may not be able to be reinvested in such away that they earn the same rate of return as the invested fundsthat generated them. For example, falling interest rates mayprevent bond coupon payments from earning the same rate ofreturn as the original bond.

If an investor is to realize the required yield on an investment in acoupon bond, then he/she must be able to invest all of thecoupon payments at that same yield as well. This yield is calledyield to maturity, which refers to the percentage rate of returnpaid on a bond if the investor buys and holds it to its maturitydate. If the coupon payments arrive when yields are lower, thenthey can only be invested at lower rates. This is reinvestment

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risk. It is the risk that proceeds available for reinvestment mustbe reinvested at a lower interest rate than the instrument thatgenerated the proceeds.

Three factors affect this risk:

Maturity:

The yield to maturity measure for long-term coupon bonds tellslittle about the potential yield that an investor may realize if thebond is held to maturity. The risk that the coupon payments willbe reinvested at less than the original yield to maturity is thereinvestment risk. The longer the maturity, the bigger thereinvestment risk.

Coupon rate:

The higher the coupon rate, the larger the size of the cash flowsto be reinvested, and the bigger the reinvestment risk. Thereforea zero-coupon bond has zero reinvestment risk if held tomaturity, and a premium bond has bigger reinvestment risk thana discount bond.

Call, prepayment options and amortizing securities:

The reinvestment risk is even greater for these kinds ofsecurities. A callable bond has higher reinvestment risk than astandard bond, because it is likely that the cash flows of thecallable bond may be received faster due to the call feature. In adeclining interest rate environment borrowers will acceleratetheir prepayments and force the investor to reinvest moreproceeds at lower interest rates.

Risk Measurement Techniques:

There are various techniques for measuring exposure of banks tointerest rate risks:

Gap analysis model:



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Measures the direction and extent of asset-liability mismatchthrough either funding or maturity gap. It is computed for assetsand liabilities of differing maturities and is calculated for a settime horizon. This model looks at the repricing gap that existsbetween the interest revenue earned 9n the bank's assets andthe interest paid on its liabilities over a particular period of time(Saunders, 1997). It highlights the net interest income exposureof the bank, to changes in interest rates in different maturitybuckets. Repricing gaps are calculated for assets and liabilities ofdiffering maturities.

A positive gap indicates that assets get repriced before liabilities,whereas, a negative gap indicates that liabilities get repricedbefore assets. The bank looks at the rate sensitivity (the time thebank manager will have to wait in order to change the postedrates on any asset or liability) of each asset and liability on thebalance sheet. The general formula that is used is as follows:

NIIi = R i (GAPi)

While NII is the net interest income, R refers to the interest ratesimpacting assets and liabilities in the relevant maturity bucketand GAP refers to the differences between the book value of therate sensitive assets and the rate sensitive liabilities. Thus whenthere is a change in the interest rate, one can easily identify the

impact of the change on the net interest income of the bank.Interest rate changes have a market value effect. The basicweakness with this model is that this method takes into accountonly the book value of assets and liabilities and hence ignorestheir market value. This method therefore is only a partialmeasure of the true interest rate exposure of a bank.

Limitations of GAP Analysis:

1. The gap is computed as the rupee difference between the

values of rate sensitive assets and liabilities in the gapping periodregardless of when the repricing occurs. Thus if all assets re-priceat the beginning of the maturity period and the liabilities at theend of the period the institution will not be insulated from interestrate risk even though the gap is maintained at zero.



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2. The gap management might be hampered by the objectives ofthe customers. In rising interest rate scenarios gap managementrecommends shifting out of fixed rate assets to floating rateassets. The customers may however demand fixed rate assets.Additionally such adjustments in assets/liabilities may have to beaccomplished at the cost of trading off lower interest rate risk forgreater credit and default risk.

3. Alternatively, such assets may be swapped at floating ratethrough OIS. However, there has to be a definite view onmagnitude as well as quantum of interest rate increase, as therewill be opportunity loss through negative carry at the beginning.

4. Gap management does not take into account that re-pricingspreads of assets and liabilities which may not be identical i.e. itis possible that the rise in interest rates on liabilities isproportionately higher than rise in interest rate on assets leadingto a decline in spreads despite an increase in the general level ofrates.

5. Gap management concentrates solely on flow of funds andvariability of revenues and does not focus on the effect of interestrate on the market value of assets and liabilities.

Duration model:

Duration is an important measure of the interest rate sensitivityof assets and liabilities as it takes into account the time of arrivalof cash flows and the maturity of assets and liabilities. It is theweighted average time to maturity of all the preset values of cashflows. Duration basically refers to the average life of the asset orthe liability.

DP p = D ( dR /1+R)

The above equation describes the percentage fall in price of thebond for a given increase in the required interest rates or yields.

The larger the value of the duration, the more sensitive is theprice of that asset or liability to changes in interest rates. As perthe above equation, the bank will be immunized from interestrate risk if the duration gap between assets and the liabilities is



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zero. The duration model has one important benefit. It uses themarket value of assets and liabilities.

Value at Risk:

Value at risk refers to the maximum expected loss that a bankcan suffer over a target horizon, given a certain confidenceinterval. It enables the calculation of market risk of a portfolio forwhich no historical data exists. It enables one to calculate the networth of the organization at any particular point of time so that itis possible to focus on long-term risk implications of decisions

that have already been taken or that are going to be taken. It isused extensively for measuring the market risk of a portfolio ofassets and/or liabilities.

VAR summarizes the predicted maximum loss (or worst loss) overa target horizon within a given confidence level. The well-knownproprietary models that use VAR approaches are JP Morgans Riskmetrics, Bankers trust Risk Adjusted Return on Capital, andChases Value at risk.

Generally there are three ways of computing VAR:

Parametric method or Variance covariance approach

Historical Simulation

Monte Carlo method

Banks are encouraged to calculate their risk profile using VARmodels. At the minimum banks are expected to adopt relativelysimple risk measurement methodologies such as maturitymismatches, sensitivity analysis etc.

Simulation:



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Simulation models help to introduce a dynamic element in theanalysis of interest rate risk. Gap analysis and duration analysisas stand-alone too1for asset-liability management suffer fromtheir inability to move beyond the static analysis of currentinterest rate risk exposures. Basically simulation models utilizecomputer power to provide what if scenarios, for example:

What if:

The absolute level of interest rates shift

There are nonparallel yield curve changes

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 the traditional methods andimproves the information available to management in terms of:

Accurate evaluation of current exposures of asset andliability portfolios to interest rate risk

Changes in multiple target variables such as net interest

income, capital adequacy, and liquidity Future gaps

It is possible that the simulation model due to the nature ofmassive paper outputs may prevent us from seeing wood for thetree. In such a situation, it is extremely important to combinetechnical expertise with an understanding of issues in theorganization. There are certain requirements for a simulationmodel to succeed. These pertain to accuracy of data andreliability of the assumptions made. In other words, one should be

in a position to look at alternatives pertaining to prices, growthrates, reinvestments, etc., under various interest rate scenarios.This could be difficult and sometimes contentious.

It is also to be noted that managers may not want to documenttheir assumptions and data is not easily available for differentialimpacts of interest rates on several variables. Hence, simulationmodels need to be used with caution particularly in the Indian



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situation. Last but not the least, the use of simulation modelscalls for commitment of substantial amount of time andresources. If we cannot afford the cost or, more importantly thetime involved in simulation modeling, it makes sense to stick tosimpler types of analysis.

Pre - Conditions for the Success of ALM in Banks:

1. Awareness for ALM in the Bank staff at all levels is a must.Thus the banks must have a supportive management & dedicatedteams in order to make sure that there is sufficient awarenessabout the importance and significance of asset liabilitymanagement among bank staff at all levels. This will enable the

bank to take corrective strategies in case of mismatch.

2. Method of reporting data from Branches / other Departments.(I.e. Strong MIS). If a bank has a strong MIS then it would not onlybe able to meet all its set targets efficiently but also enhance thebanks overall profitability.

3. A bank must have full computerization and networkingbecause only then it would be able to perform its tasks well andin an efficient manner. It will also give it a competitive edge and

help to achieve a reliable position in the eyes of its customers.

4. There must be sufficient insight into the banking operations,economic forecasting, computerization, investment and credit.

This will enable the bank to take required steps in case of anycrisis or financial instability.



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5. It is necessary to link up ALM to future Risk ManagementStrategies. This will help the bank to take the right decisions atthe right time and frame risk management strategies accordingly.

This will enable the bank to avoid difficulties and hindrances inperforming its operational functions efficiently.

Asset - Liability Management Strategies forCorrecting Mismatch:

The strategies that can be employed for correcting the mismatchin terms of D (A) > D (L) can be either liability or asset driven.Asset driven strategies for correcting the mismatch focus onshortening the duration of the asset portfolio. The commonlyemployed asset based financing strategy is securitization.

Typically the long-term asset portfolios like the lease and hirepurchase portfolios are securitized; and the resulting proceedsare either redeployed in short term assets or utilized for repayingshort-term liabilities.

Liability driven strategies basically focus on lengthening thematurity profiles of liabilities. Such strategies can include forinstance issue of external equity in the form of additional equityshares or compulsorily convertible preference shares (which can

also help in augmenting the Tier I capital of finance companies),issue of redeemable preference shares, subordinated debtinstruments, debentures and accessing long term debt like bankborrowings and term loans. Strategies to be employed forcorrecting a mismatch in the form of D (A) < D (L) (which will benecessary if interest rates are expected to decline) will be thereverse of the strategies discussed above.

Asset driven strategies focus on lengthening the maturity profileof assets by the deployment of available lendable resources in

long-term assets such as lease and hire purchase. Liability drivenstrategies focus on shortening the maturity profile of liabilities,which can include, liquidating bank borrowings which areprimarily in the form of cash credit (and hence amenable forimmediate liquidation), using the prepayment options (if anyembedded in the term loans); and the call options, if anyembedded in bonds issued by the company; and raising short-



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term borrowings (e.g.: fixed deposits with a tenor of one year) torepay long-term borrowings.

Positive Mismatch: M.A.>M.L. & Negative Mismatch: M.L.>M.A.

In case of positive mismatch, excess liquidity can be deployed inmoney market instruments, creating new assets & investmentswaps etc.

For negative mismatch, it can be financed from marketborrowings (Call/Term), Bills rediscounting, Repos & deploymentof foreign currency converted into rupee.

Strategy: To meet the mismatch in any maturity bucket, the bankhas to look into taking deposit and invest it suitably so as to

mature in time bucket with negative mismatch. The bank canraise fresh deposits of Rs 300 crore over 5 years maturities andinvest it in securities of 1-29 days of Rs 200 crores and restmatching with other out flows.

Maturity Pattern of Assets & Liabilities of a Bank:



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Information Technology and Asset - LiabilityManagement in the Indian context:

Many of the new private sector banks and some of the non-banking financial companies have gone in for complete

N.L.Dalmia Institute of Management Studies and Research

Liability/AssetsRupees

(In Cr)In Percentage

I. Deposits

a. Up to 1 year

b. Over 1 yr to 3 yrsc. Over 3 yrs to 5 yrs

d. Over 5 years

15200

8000

6700230

270

100

52.63

44.081.51

1.78

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

450

180

00

150

120

100

40.00

0.00

33.33

26.67

III. Loans & Advances

a. Up to 1 yearb. Over 1 yr to 3 yrs


d. Over 5 years

8800

34003000

400

2000

100

38.6434.09

4.55

22.72

Iv. Investment

a. Up to 1 year

b. Over 1 yr to 3 yrs


d. Over 5 years

5800

1300

300

900

3300

100

22.41

5.17

15.52

56.90

43


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computerization of their branch network and have also integratedtheir treasury, Forex, and lending segments. The informationtechnology initiatives of these institutions provide significantadvantage to them in asset-liability management since itfacilitates faster flow of information, which is accurate andreliable. It also helps in terms of quicker decision-making from thecentral office since branches are networked and accounts areconsidered as belonging to the bank rather than a branch.

The electronic fund transfer system as well as Demat holding ofsecurities also significantly alters mechanisms of implementingasset-liability management because trading, transaction, andholding costs get reduced. Simulation models are relatively easierto consider in the context of networking and also computingpowers. The open architecture, which is evolving in the financialsystem, facilitates cross-bank initiatives in asset-liabilitymanagement to reduce aggregate unit cost. This would prove asa reliable risk reduction mechanism. In other words, theboundaries of asset-liability management architecture itself ischanging because of substantial changes brought about byinformation technology, and to that extent the operationsmanagers are provided with multiple possibilities which were notearlier available in the context of large numbers of branchnetworks and associated problems of information collection,storage, and retrieval.

In the Indian context, asset-liability management refers to themanagement of deposits, credit, investments, borrowing, Forexreserves and capital, keeping in mind the capital adequacy normslaid down by the regulatory authorities. Information technologycan facilitate decisions on the following issues:

Estimating the main sources of funds like core deposits,certificates of deposits, and call borrowings.

Reducing the gap between rate sensitive assets and rate

sensitive liabilities, given a certain level of risk. Reducing the maturity mismatch so as to avoid liquidity

problems.

Managing funds with respect to crucial factors like size andduration.



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Emerging Issues in the Indian context:

With the onset of liberalization, Indian banks are now moreexposed to uncertainty and to global competition. This makes itimperative to have proper asset-liability management systems in

place.

The following points bring out the reasons as to why asset-liabilitymanagement is necessary in the Indian context:

1. In the context of a bank, asset-liability management refers tothe process of managing the net interest margin (NIM) within agiven level of risk. NIM = Net Interest Income/Average EarningAssets = NII/AEA

Since NII equals interest income minus interest expenses, thus

NIM can be viewed as the spread on earning assets and uses theterm spread management. As the basic objective of banks is tomaximize income while reducing their exposure to risk, efficientmanagement of net interest margin becomes essential.



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2. Several banks have inadequate and inefficient managementsystems that have to be altered so as to ensure that the banksare sufficiently liquid.

3. Indian banks are now more exposed to the vagaries of theinternational markets, than ever before because of the removal ofrestrictions, especially with respect to Forex transactions. Asset-liability management becomes essential as it enables the bank tomaintain its exposure to foreign currency fluctuations given thelevel of risk it can handle.

4. An increasing proportion of investments by banks are beingrecorded on a marked-to-market basis and as such large portionof the investment portfolio is exposed to market risks. Counteringthe adverse impact of these changes is possible only through

efficient asset-liability management techniques.

5. As the focus on net interest margin has increased over theyears, there is an increasing possibility that the risk arising out ofexposure to interest rate volatility will be built into the capitaladequacy norms specified by the regulatory authorities. This, inturn will require efficient asset-liability management practices.



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Conclusion:

It is important to note that the conglomerate approach tofinancial institutions, which is increasingly becoming popular inthe developed markets, could also get replicated in Indiansituations. This implies that the distinction between commercialbanks and term lending institutions could become blurred. It isalso possible that the same institution involves itself in short-termand long-term lending-borrowing activities, as well as otheractivities like mutual funds, insurance and pension funds.

In such a situation, the strategy for asset-liability managementbecomes more challenging because one has to adopt a modularapproach in terms of meeting asset liability managementrequirements of different divisions and product lines. But it alsoprovides opportunities for diversification across activities thatcould facilitate risk management on an enhanced footing. In otherwords, in the Indian context, the challenge could arise from saythe merger of SBI, IDBI, and LIC.

Such a scenario need not be considered extremely hypotheticalbecause combined and stronger balance sheets provide muchgreater access to global funds. It also enhances the capability of

institutions to significantly alter their risk profiles at short noticebecause of the flexibility afforded by the characteristics ofproducts of different divisions. This also requires significantmanagerial competence in order to have a conglomerate view ofsuch organizations and prepare it for the challenges of thecoming decade.

As long as the artificial barriers between different financialinstitutions exist, asset liability management is narrowly focusedand many a time not in a position to achieve the desired

objectives. This is because of the fact that the institutionalarrangements are mainly due to historical reasons of convenienceand a perceived static picture of the operating world. Theintegration of different financial markets, instruments andinstitutions provide greater opportunities for emerging marketslike India to aim for higher return in the context of minimizingrisk.



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Financ ial Risk Management In Banking: The Theory andApplication of Asset and Liability Management by Dennis G.Uyemura and Donald R. van Deventer

Asset and Liability Management Tools: A Handbook for Best

Practice by Bernd Scherery
http://www.amazon.com/Financial-Risk-Management-Banking-Application/dp/1557383537/ref=sr_1_4?ie=UTF8&s=books&qid=1235821222&sr=1-4http://www.amazon.com/Financial-Risk-Management-Banking-Application/dp/1557383537/ref=sr_1_4?ie=UTF8&s=books&qid=1235821222&sr=1-4http://www.amazon.com/Asset-Liability-Management-Tools-Handbook/dp/1904339069/ref=sr_1_7?ie=UTF8&s=books&qid=1235821222&sr=1-7http://www.amazon.com/Asset-Liability-Management-Tools-Handbook/dp/1904339069/ref=sr_1_7?ie=UTF8&s=books&qid=1235821222&sr=1-7http://www.amazon.com/Financial-Risk-Management-Banking-Application/dp/1557383537/ref=sr_1_4?ie=UTF8&s=books&qid=1235821222&sr=1-4http://www.amazon.com/Financial-Risk-Management-Banking-Application/dp/1557383537/ref=sr_1_4?ie=UTF8&s=books&qid=1235821222&sr=1-4http://www.amazon.com/Asset-Liability-Management-Tools-Handbook/dp/1904339069/ref=sr_1_7?ie=UTF8&s=books&qid=1235821222&sr=1-7http://www.amazon.com/Asset-Liability-Management-Tools-Handbook/dp/1904339069/ref=sr_1_7?ie=UTF8&s=books&qid=1235821222&sr=1-7

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