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Asset Liability Management
Dr. P. K. Gupta
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Foc us Areas f o r a FI
N et interest in co me
Market value o f st oc kh o lders' equity
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B uilding B loc ks ALM
Risk Drivers
Risk Exp o sures
Standal o ne Risk
Co rrelati o ns
P o rtf o lio Risk
Eco n o mi c Capital
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W hat is ALM?
Managing a bank's entire balan c e sheet as a
dynami c system o f interrelated a cco unts and
transa c tio ns.ALM tend t o stru c ture the time s c hedule o f assets
and liabilities l o ans and dep o sits t o c lo se the
defi c it o r ex c ess liquidity gaps.
F uture defi c it require funding triggering interest
rate risks
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Reas o ns f o r ALM imp o rtan c e
VolatilityFinancial innovations
Regulatory PressuresManagement Recognition
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Asset and liability management co mmittee(ALCO)
A bank's asset and liability management co mmittee
(ALCO) coo rdinates all p o lic y de c isi o ns and
strategies that determine a bank's risk pr o fit and
pr o fit o bje c tives.
Interest rate risk management is the primary
resp o nsibility o f this co mmittee .
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Illustrati o n Pri c e & Maturity Mat c hing
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Maturity Mat c hing
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Interest Rate Risk is the p o tential variability in
a bank's net interest in co me and market value
o f equity due t o c hanges in the level o f
market interest rates.
Interest rate risk
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Interest Rate Risk Subtypes
Prepayment RiskCall/Put Risk
Volatility RiskRate Level RiskReinvestment Risk
Basis Risk(short run)Real interest rate risk
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W hat determines rate sensitivity?
In general, an asset o r liability is n o rmallyc lassified as rate-sensitive with a time frame if:
It matures
It represents and interim, o r partial, prin c ipalpaymentThe interest rate applied t o o utstanding prin c ipalc hanges co ntra c tually during the intervalThe o utstanding prin c ipal c an be repri c ed when
s o me base rate o f index c hanges and managementexpe c ts the base rate / index t o c hange during theinterval
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Interest Rate Gaps
Fixed Interest Rate Gap = Fixed Rate Assets-Fixed Rate Liabilities
Variable Interest Rate Gap = InterestSensitive Assets- Interest Sensitive LiabilitiesInterest Rate Gap=Average Reset Dates of
Assets - liabilities
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P o sitive and negative gaps
Positive GAPimplies a bank has m o re rate sensitive assetsthan liabilities, and that net interest in co me willgenerally rise (fall) when interest rates rise (fall).
N egative GAPimplies a bank has m o re rate sensitive liabilities
than rate sensitive assets, and that net interestin co me will generally fall (rise) when interest ratesrise (fall).
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Maturity Gap Analysis
Rate Sensitive Gap = Rate Sensitive Assets-
Rate Sensitive Liabilities
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Illustrati o n o f Gaps
Rate Sensitive Gap = RSA-RSL
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Rate Adjusted Gap
T he above percentages are movements in the value of assets andliabilities
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F a c to rs affe c ting NIIChanges in the level o f i-rates .
( NII = (GAP) * ( ( iexp .)
assumes a parallel shift in the yield c urve whi c h rarely
occ urs
Changes in the sl o pe o f the yield c urve o r the relati o nship
between asset yields and liability co st o f funds
Changes in the v o lume o f assets and liabilities
Change in the co mp o siti o n o f assets and liabilities
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Interest rate risk
Example: Rs. 50,000 l o an4 year l o an at 8.5%1 year debt at 4.5%
Spread 4.0%F unding GAP
GAP = RSA - RSL,GAP = 50,000This is a negative GAP.
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F unding GAP
Foc uses o n managing NII in the sh o rt run.
Gr o up assets and liabilities int o time"bu c kets a cco rding t o when they mature o r are expe c ted t o re-pri c eCal c ulate GAP f o r ea c h time bu c ketF unding GAP at per the bu c ket
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Traditi o nal stati c GAP analysis
Fo re c asting the interest rateSele c ting a series o f time bu c kets (intervals) f o r determining when assets and liabilities are rate-sensitiveGr o uping assets and liabilities int o time "bu c kets"
a cco rding t o when they mature o r re-pri c eThe effe c ts o f any o ff-balan c e sheet p o siti o ns(swaps, futures, et c .) are added t o the balan c esheet p o siti o nCal c ulate GAP f o r ea c h time bu c ketF
unding GAP t = Value RSA t - Valueo
r RSL twhere t = time bu c ket; e.g., 0-3 m o nthsManagement f o re c asts NII given the interest rateenvir o nment
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Expe c ted balan c e sheet f o r hyp o theti c al bank
Expe c ted Balan c e heet f o r Hyp o theti c al Bankssets Yield iabilities o st
ate sensiti e 6Fixed rate 22 6No n earnin
92E ity
o tal
6
NII x + x x 6 + 6 x 22
NI 6NII 7 7 2
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F a c to rs affe c ting net interest in co me
Change in the level of all short-term rates
Change in spread between assets yields and
interest cost (non-parallel shift in yield curve)Proportionate doubling in size .
Increase in RSAs and decrease in RSLs
RSA = 540, fixed rate = 310RSL = 560, fixed rate = 260 .
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In co me Sensitivity
Changes in NII are dire c tly pr o p o rti o nal t o the size o f the GAP( NII exp = (GAP) * ( ( iexp )
The larger is the GAP, the greater is the d o llar c hange in NII .*This applies o nly in the c ase o f a parallel shift in theyield c urve, whi c h is rare.
If rates d o n o t c hange by the same am o unt, thenthe GAP may c hange by m o re o r less.
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Advantages / disadvantages o f GAP
T he primary advantage of GAP analysis is itssimplicity . T he primary weakness is that it ignores thetime value of money . GAP further ignores the impact of embeddedoptions . For this reason, most banks conduct earningssensitivity analysis, or pro forma analysis, toproject earnings and the variation in earningsunder different interest rate environments .
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Embedded o pti o nsCustomers have different types of options,both explicit and implicit:
Option to refinance a loanCall option on a federal agency bond the bankownsDepositors option to withdraw funds prior to
maturity
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The impli c ati o ns o f embedded o pti o ns
Is the bank the buyer o r seller o f the o pti o nDo es the bank o r the c ust o mer determine whenthe o pti o n is exer c ised?
o w and by what am o unt is the bank being
co mpensated f o r selling the o pti o n, o r h o w mu c hmust it pay t o buy the o pti o n?W hen will the o pti o n be exer c ised?
Often determined by the e co n o mi c and interest
rate envir o
nmentStati c GAP analysis ign o res these embeddedo pti o ns
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Interest rate risk management measures
Cal c ulate peri o di c GAPs o ver sh o rt timeintervals.Mat c h fund repri c eable assets with similar repri c eable liabilities s o that peri o di c GAPsappr o a c h zer o .Mat c h fund l o ng-term assets with n o n interest-bearing liabilities.Use o ff-balan c e sheet transa c tio ns, su c h asinterest rate swaps and finan c ial futures, t ohedge.
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Vari o us ways t o adjust the effe c tive rate sensitivity o f abanks assets and liabilities o n-balan c e sheet.
Obje c tive Appr o a c hes
Redu c e assetsensitivity
B uy l o nger-term se c urities.Lengthen the maturities o f lo ans.Mo ve fr o m fl o ating-rate l o ans t o term l o ans.
In c rease assetsensitivity
Buy sh
ort-term se
curities.Sh o rten l o an maturities.
Make m o re l o ans o n a fl o ating-rate basis.
Redu c e liabilitysensitivity
Pay premiums t o attra c t l o nger-term dep o sitinstruments.Issue l o ng-term sub o rdinated debt.
In c rease liabilitysensitivity
Pay premiums t o attra c t sh o rt-term dep o sitinstruments.B o rr o w m o re via n o n- co re pur c hasedliabilities.
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Liquidity Risk
Arises due to mismatch of assets andliabilities with respect to size and maturity
Makes banks vulnerable to market liquidityriskT ime profile of gaps results from projected
assets and liabilities at different future timepoints .
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Gap Stru c ture
Rate Assets = 95Fixed Assets = 15
Liabilities = 50Equity = 30Liquidity Gap = 30
- ive value indicates deficits
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LG and LR
If L > A , it indicates excessIF A>L , it indicates deficit
Related aspects- N eed for funds/investments
- Maturity Mismatch
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Cash Mat c hing
Matching the time profile of the amortizationof assets and liabilitiesT
his makes liquidity gap = 0Fixed Rate vs . Floating Rate Matching
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Gap CalculationDate 1 3 4 5
A 150 140 130 1 0 110
L 150 130 1 0 100 105
G 0 10 0 0 0
A-Am o rtizati o n -10 -10 -10 -10
L- Am o rtizati o n - 0 -10 -10 -5
Marginal G 10 0 0 -5
Cum. Marginal G 10 10 10 5
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