Study of asset liability management in Indian banks.

Introduction

Asset Liability Management (ALM) defines management of all assets and

liabilities (both off and on balance sheet items) of a bank. It requires assessment

of various types of risks and altering the asset liability portfolio to manage risk.

Till the early 1990s, the RBI did the real banking business and commercial banks

were mere executors of what RBI decided. But now, BIS is standardizing the

practices of banks across the globe and India is part of this process. The success

of ALM, Risk Management and Basel Accord introduced by BIS depends on the

efficiency of the management of assets and liabilities. Hence these days without

proper management of assets and liabilities, the survival is at stake. A bank’s

liabilities include deposits, borrowings and capital. On the other side pf the

balance sheets are assets which are loans of various types which banks make to

the customer for various purposes. To view the two sides of banks’ balance

sheet as completely integrated units has an intuitive appeal. But the nature,

profitability and risk of constituents of both sides

should be similar. The structure of banks’. balance sheet has direct implications

on profitability of banks especially in terms of Net Interest Margin (NIM). So it is

absolute necessary to maintain compatible asset-liability structure to maintain

liquidity, improve profitability and manage risk under acceptable limits.

ALM MODELS

Analytical models are very important for ALM analysis and scientific decision

making. The basic models are:

1. GAP Analysis Model

2. Duration GAP Analysis Model

3. Scenario Analysis Model

4. Value at Risk (VaR) model

5. Stochastic Programming Model

Any of these models is being used by banks through their Asset Liability

Management Committee (ALCO). The Executive Director and other vital

departments’ heads head ALCO in banks. There are minimum four members and

maximum eight members. It is responsible for Responsible for Setting business

policies and strategies, Pricing assets and liabilities, Measuring risk, Periodic

review, Discussing new products and Reporting.

OBJECTIVES OF THE STUDY

Though Basel Capital Accord and subsequent RBI guidelines have given a

structure for ALM in banks, the Indian Banking system has not enforced the

guidelines in total. The banks have

formed ALCO as per the guidelines; but they rarely meet to take decisions.

Public Sector banks are yet to collect 100% of ALM data because of lack of

computerization in all branches. With this background, this research aims to find

out the status of Asset Liability Management across all commercial banks in India

with the help of multivariate technique of canonical correlation. The discussion

paper has following objectives to explore:

• To study the Portfolio-Matching behavior of Indian Banks in terms of nature and

strengths of relationship between Assets and Liability

• To find out the component of Assets explaining variance in Liability and

viceversa

• To study the impact of ownership over Asset Liability management in Banks

• To study impact of ALM on the profitability of different bank-groups

METHODOLOGY

The study covers all scheduled commercial banks except the RRBs (Regional

Rural Banks).

The period of the study was from 1992 – 2004. The banks were grouped based

on ownership structure. The groups were

1. Nationalized Banks except SBI & Associates ( 19 )

2. SBI and Associates ( 8)

3. Private Banks( 30)

4. Foreign Banks(36)

RECLASSIFICATION OF ASSETS &LIABILITIES

The assets and liabilities of a Bank are divided into various sub heads. For the

purpose of the study, the assets were regrouped under six major heads and the

liabilities were regrouped under four major heads as shown in table below. This

classification is guided by prior information on the liquidity-return profile of assets

and the maturity-cost profile of liabilities. The reclassified assets and liabilities

covered in the study exclude ‘other assets’ on the asset side and ‘other liabilities’

on the liabilities side. This is necessary to deal with the problem of singularity

– a situation that produces perfect correlation within sets and makes correlation

between sets meaningless. The relevant data has been collected from the RBI

website.

CANONICAL CORRELATION ANALYSIS

Multivariate statistical technique, canonical correlation has been used to access

the nature and strength of relationship between the assets and liabilities. To

explore the relationship between assets and liabilities, we could merely compute

the correlation between each set of assets and each set of liabilities.

Unfortunately, all of these correlations assess the same hypothesis - that assets

influence liabilities. Hence, a Bonferroni adjustment needs to be applied. That is,

we should divide the level of significance by the number of correlations. This

Bonferroni adjustment, of course, reduces the power of each correlation and thus

can obscure the findings. Canonical correlation provides a means to explore all

of the correlations concurrently andthus obviates the need to incorporate a

Bonferroni adjustment. The technique reduces the relationship into a few

significant relationships.The essence of canonical correlation Measures the

strength of relationship between two sets of variables (Assets (6) & Liabilities (4)

in this case) by establishing linear combination of variables in one set and a

linear combinations of variables in other set. It produces an output that shows the

strength of relationship between two variates as well as individual variables

accounting for variance in other set

.

A = A1 * (Liquid Assets) + A2 * (SLR Securities)+ A3 * (Investments) + A4 *

(Term Loans) + A5 *

(Short Term Loans) + A6 * (Fixed Assets)

B = B1 * (Net Worth) + B2* (Borrowings) + B3 *(Short Term Deposits) + B4 *

(Long Term Deposits)

To begin with, A and B (called canonicalvariates) are unknown. The technique

tries to compute the values of Ai and Bi such that the covariance between A & B

is maximum.

Foreign Banks Pvt Banks Nationalised Banks

SBI & Associates

R square 0.948 0.997 0.987 0.998Canonical LoadingsAssetsLA 0.243 0.716 -0.046 0.237SLR 0.078 0.712 -0.328 0.744INV 0.314 -0.467 -0.662 0.858TL -0.469 -0.464 0.188 0.568STL 0.268 0.461 0.747 -0.88FA -0.903 -0.945 -0.728 0.644LiabilitiesNW -0.664 -0.948 -0.885 0.831BOR 0.171 -0.523 0.593 -0.83STD 0.498 0.972 0.126 -0.457LTD -0.255 -0.201 0.007 0.964

RedundancyAsset 0.212 0.426 0.279 0.476Liability 0.196 0.539 0.288 0.629

The first row (R2) is a measure of the significance of the correlation. In this case

all the correlations are significant. The canonical loading is a measure of the

strength of the association i.e. it is the percent of variance linearly shared by an

original variable with one of the canonical variates. A loading greater that 40% is

assumed to be significant. A negative loading indicates an inverse relationship.

For example, for Foreign Banks, Fixed Assets (FA) under Assets has a loading of

-0.903 and Net Worth (NW) under liabilities has a loading of

-0.664. Since both are negative this means there is a strong correlation between

FA and NW. Similarly for Foreign Banks, we can observe that there is a strong

negative correlation betweenshort term deposit with both Term Loan and Fixed

Asset.

OBSERVATIONS

As per the summary table above, the canonical co-relation coefficients of

different set of banks indicate that different banks have different degree of

association among constituents of assets and liabilities. Bank-Groups can be

arranged in decreasing order of correlation:

– SBI & Associates

– Private Banks

– Nationalized Banks

– Foreign Banks

Redundancy factors indicate how redundant oneset of variables is, given the

other set of variable which gives an idea about independent anddependent sets.

This also gives an idea aboutthe fact that whether the bank is assetmanaged or

liability managed. Looking at the redundancy factors, the independent and

dependent sets for different bank- groups can beidentified:

Other than foreign bank groups, all other three have asset as their independent

set. This means during the study period (1992-2004), these banks were actively

managing assets and liability was dependent upon how well the assets are

managed. This is in perfect consonance with the macro indicators. The interest

rates were coming down all these years and banks were busy in parking their

assets in different avenues where they could get maximum return. Lately, the

scenario has changed in terms of interest rates. Now as there is ample liquidity in

the market, banks especially the bigger one is not concerned about the liability.

They can always borrow from active money market to manage their liability.

Foreign Banks

The canonical function coefficient or the canonical weight of different constituents

in case of foreign banks Term Loans and Fixed Assets form asset side and Net

Worth and Short Term Deposit from liability side have significant presence with

following interpretation:

• Very strong co-relation between Fixed Assetand Net Worth.

• Strong negative correlation between short term deposit with both Term Loan

and Fixed Asset. This indicates-

• Proper usage of short term deposit.

• Not used for long term assets or long term loans.

Private Banks

In case of private banks all constituents of asset side Liquid Assets, SLR

Securities, Short Term Loans, Investments, Term Loans, and Fixed Asset are

significantly explaining the co-relation while on liability side only Net Worth and

Short Term Deposit are contributing. This shows how actively these banks

manage their asset to generate maximum return. This relationship can

be interpreted in the following ways:

• Very strong co-relation between FA and NW.

• Short Term Deposits is used for Liquid Assets, SLR and Short Term Loans. As

defined above LA, SLR and STL – all are highly liquid section of assets. So it is

very prudent to employ short term deposit.

• Borrowings are used for Investment and Term Loans. As defined, borrowings

are near maturity liability while investment and term loans are of long term

maturity. So the private banks are using risky strategy of deploying short term

fund in long term investment which is clearly against right

asset-liability management. Under normal circumstances long term investment

gives better returns, so this strategy is to generate additional profitability at the

cost of liquidity. However as the money market has become more matured, it is

easy to manage liquidity without much of risk.

Nationalized Banks

In case of nationalized banks Investment, short term loan, fixed asset contribute

significantly in explaining asset part while net worth and borrowings constituent of

liability is major factor.

The major interpretations are:

• Very strong co-relation between FA and NW.

• Nationalized banks use Borrowings for Short Term Loans.

• There is negative co-relation between Borrowings and investment.

• More concerned with liquidity than profitability

• Conservative strategy ( in comparison toPrivate Banks)

• Good short term maturity/liquidity management

Nationalized banks use a borrowing (which is near term maturity) for short term a

loan which is effective way of ALM. However nationalized banks deploy long term

liability in short term assets. This is distinctly different from private banks

strategy. The nationalized banks are more concerned about liquidity than

profitability.

SBI & Associates

For SBI group all constituents of Liability namely Net worth, borrowings, short

term deposits and long term deposits are significant while in assets side SLR

investment, Investments, Term loans and fixed assets are significant. Following

can be interpreted:

• Very strong correlation between FA and NW

• Strong correlation between Borrowings and STL.

• Correlation between Long term Deposits and ‘Term Loans, Investment and

SLR’.

• Short Term Deposits and Short Term Liabilities are correlated.

• Most Conservative strategy

• Over concerned with liquidity

• Use Long term funds for Long as well as

medium & short term loans Among all bank-groups, SBI & Associates seem to be

most prudent asset liability management as short term liability is matched with

short term asset and long term assets is matched with long term liability. But at

the same time, this group deploy long term fund for medium and short term

loans. This can be called over concerned with liquidity and that too by paying a

price in terms of less profitability by foregoing the opportunity to deploy them in

long term assets.

PROFITABILITY ANALYSIS OF BANKS

As discussed above, private banks are more aggressive in managing their

portfolio for better profit realization. So let us look into the profitability of these

banks and relate that to their ALM. For this all banks are divided into two groups-

Public and Private. Nationalized along with SBI are clubbed together as public

banks while foreign and private banks are clubbed together as private banks.

The profit figures can be compared in terms of Net Profit Margin, Return on Net

Worth and Equity Multiplier. Following graph depicts the comparison The above

comparison shows that till 2002, private banks were better in terms of profitability

indicators. The aggressive strategy adopted by them in terms of deploying asset

for long term is being reflected in the better profitability as compared to public

sector banks. Since 2002, the public banks have caught up with private banks.

This can be due to second generation banking reforms, deregulation and more

autonomy given to the banks in terms of directed credit and regulated interest

rates.

NET PROFIT MARGIN (%)

0

2

4

6

8

10

12

14

16

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

Public

Private

RETURN ON NET WORTH (%)

0

5

10

15

20

25

30

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

Public

Private