Asset Liability Management

PGP 2007-09 : Term III

Commercial Banking Asset Liability Management April 2008

Pre-Financial Sector Reforms (1991) • • • • • • • • •

Geographical spread of Bank branches Directed Investments / Credit Programs Administered Rates of Interest Accrual based accounting Problems of Recovery of Loans Deterioration in Quality of Assets /Loans Erosion of Profits No Computerisation Trade Union Issues Com Bkg 2008

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Banking Reforms 1993 onwards • • • • • • • • •

L-P-G Policy of GOI since 1991 Technological Changes – ATMs / Internet New Products and Services : Competition Narasimham Committee - I / II on Financial / Banking Sector Reforms (1991 & 1997) Capital Adequacy Ratio : IRAC Norms : NPAs Priority Sector Loans: Reduce from 40 to 10%? Reduce SLR (40%) and CRR (15%) Benchmark Prime Lending Rates Enactment / Amendments to various laws Com Bkg 2008

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Banking Sector Reforms ……. • • • • • • •

Market determined Rates of Interest No directed lending or investments Organisational Changes : Transparency 4 way classification of Loan Accounts / Assets Provisioning for Losses o/a NPAs & Std Assets ALM (1999) and Risk Management, KYC in Banks Non Performing Assets definition revised from 4 quarters (1993) dues in Principal & Interest to 3 (1994) to 2 (1995) quarters and now from April 01, 2004 – just 90 days / 1 quarter ! • Basel II norms for Bank Supervision from 2008! Com Bkg 2008

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ALM - Introduction Banks Economic Factors

Economic Policies

Balance Sheet of a Bank Liabilities

Assets

Capital Reserves and Surplus Deposits Borrowings Other Liabilities and Provisions Contingent Liabilities

Cash and Balances at RBI Balance with banks and money at call and short notice Investments Advances Fixed Assets Other Assets

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Risks • Various Risks – Interest Rate Risk – Foreign Exchange Risk – Liquidity Risk – Credit Risk – Contingency Risk Com Bkg 2008

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Liquidity Risk Profile of a Bank (Rs in crores)

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International Initiatives in Managing Risks • Till the 1980s, a professional risk manager was unheard of • Late 1980s, US Financial Firms started using VaR • Basel I ;1988 • Risk Metrics, 1995 • Bank for International Settlement (BIS) - a series of risk management guidelines for Banks worldwide • Market Risk Guidelines of Basel, 1996 • Basel II process ( November 2005 Document) Com Bkg 2008

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Risk Management •

How to bring it (Risks) down to manageable levels? – The 5-step process 1. 2. 3. 4. 5.

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Identification of risks Quantification Policy formulation Strategy formulation Monitoring

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WHAT IS ALM? • An attempt to match: Assets and Liabilities •

In terms of: Maturities and Interest Rates Sensitivities

•

To minimize: Interest Rate Risk and Liquidity Risk

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Asset Liability Management Asset Management

Liability Management

How Liquid are the assets of the Bank

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How easily can the Bank generate loans from market 14

Asset Liability Management • ALM is an integral part of the financial management process of any bank. • ALM is concerned with strategic balance sheet management involving risks caused by changes in the interest rates, exchange rates and the liquidity position of the bank. • While managing these three risks forms the crux of ALM, credit risk and contingency risk also form a part of the ALM Com Bkg 2008

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Asset Liability Management • ALM can be termed as a risk management technique designed to earn an adequate return while maintaining a comfortable surplus of assets beyond liabilities. • It takes into consideration interest rates, earning power, and degree of willingness to take on debt and hence is also known as Surplus Management Com Bkg 2008

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ALM and NIM • ALM is all about efficient management of balance sheet dynamics with regard to its size, constituents and quality. • It is the process of managing the Net Interest Margin (NIM) within the overall risk bearing ability of a bank • ALM process depends on the understanding of the balance sheet; the availability, accuracy, adequacy and expediency of the data and the MIS system Com Bkg 2008

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GAP Analysis • One way to measure the direction and extent of asset-liability mismatch is by using gap analysis. The analysis derives its name from the “gap” which is the difference between the amounts of Rate Sensitive Asset (RSA) and Rate Sensitive Liabilities (RSL).

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HISTORY OF ALM • Mid 1970s in the U.S.A. Deregulation of Interest Rates Interest Rate Risk Liquidity Risk Com Bkg 2008

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Definition of ALM • ALM is defined as, “the process of decision – making to control risks of existence, stability and growth of a system through the dynamic balances of its assets and liabilities.” • The text book definition of ALM is “a risk management technique designed to earn an adequate return while maintaining a comfortable surplus of assets beyond liabilities. It takes into consideration interest rates, earning power and degree of willingness to take on debt. It is also called surplus- management”. Com Bkg 2008

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SUCCESS OF ALM PROCESS The ALM process rests on Three Pillars: 3. ALM Information Systems 5. ALM Organisation 7. ALM Process

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1. ALM INFORMATION SYSTEM • • • • • • • • •

Decision Support and Reporting Tool Comparison between different Branches Product Analysis Duration Gap Analysis Risk Planning and Management Flexible Design Strategic Planning of the Asset-Liability Mix Simulation Analysis Transfer- Pricing Mechanism

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2. ALM ORGANISATION • Strong Commitment of Senior Management • ALCO should comprise the Senior Management ( including the CEO) • A Support Group of Operational Staff

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Board of Directors

Management Committee

Asset Liability Committee (ALCO)

Asset Liability Management Cell

Finance Planning Department

Credit Analysis Department

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Credit Risk Management Department

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Investment and Loan Departments

Treasury

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3. ALM PROCESS • The scope of ALM function can be described as follows: • Liquidity Risk Management • Management of Market Risks • Trading Risk Management • Funding and Capital Planning • Profit Planning and Growth Projection Com Bkg 2008

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Price Matching (Rs. cr.) *

Average cost/return on liabilities/assets. Table 1

Table 1 (Rearranged)

Liabilities Amount

Assets Amount

Rate (%)

Liabilities Amount

Rate (%)

Assets Amount

Rate (%)

Spread Rate (%)

(%)

15

0

10

0

10

0

10

0

0

25

5

20

12

5

0

5

12

12

30

12

50

15

15

5

15

12

7

30

13

20

18

10

5

10

15

10

30

12

30

15

3

10

13

10

15

2

20

13

20

18

5

100

8.75*

100

13.5*

4.75*

100

8.75*

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100

13.5*

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Table II (Rs. cr.)

Maturity Matching

Table II (Rearranged) (period in

months)

Liabili ties Maturing within (months)

Assets

Liabil ities

Assets

Gap

Cumulati ve Gap

Maturing within (months)

10

1

15

<1

10

15

-5

-5

5

3

10

3

5

10

-5

-10

8

6

5

6

8

5

3

-7

4

12

10

12

4

10

-6

-13

45

24

30

24

45

30

15

2

20

36

10

36

20

10

10

12

8

>36

20

>36ALM 2008 8

20

-12

0 29

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100

100

100

100

Risks in ALM • Interest Rate Risk: It is the risk of having a negative impact on a bank’s future earnings and on the market value of its equity due to changes in interest rates. • Liquidity Risk: It is the risk of having insufficient liquid assets to meet the liabilities at a given time. • Forex Risk: It is the risk of having losses in foreign exchange assets and liabilities due to exchanges in exchange rates among multicurrencies under consideration. Com Bkg 2008

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MANAGEMENT OF LIQUIDITY RISK • Availability of funds as & when liabilities are due • Liquidity through maturity & cash flow matching • Maturity ladder & calculation of cumulative surplus/deficits at selected dates

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MANAGEMENT OF LIQUIDITY RISK Construction of time buckets: 1 to 30/31 days Over 1 month and upto 2 months Over 2 months and upto 3 months Over 3 months and upto 6 months Over 6 months and upto 1 year Over 1 year and upto 3 years Over 3 years and upto 5 years Over 5 years Com Bkg 2008

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MANAGEMENT OF LIQUIDITY RISK • Main focus on Short Term mismatches • Mismatches during 1-30 days < 20 % of cash outflows in the same bucket • For higher limits, special sanction from the Board • Statement of Structural Liquidity (maturity ladder) Com Bkg 2008

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MANAGEMENT OF Interest Rate Risk • • • 4. 5. 6. 7.

Impact on Net Interest Income (NII) Long term impact on market value/ net worth Techniques: Gap Analysis Duration Gap Analysis Simulation Value at Risk

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1. GAP ANALYSIS • Calculating Gap over different time intervals at a given date • Mismatches between RSL and RSA • ∆GAP = RSA(∆ i) - RSL(∆ i) = NII(∆ i) for each time bucket • Positive GAP ( RSA > RSL ) – Increasing Interest Rates would be beneficial for a Bank • Negative GAP ( RSL > RSA ) – Falling Interest Rates would be beneficial for a Bank Com Bkg 2008

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9. Control Framework 8. Regulatory Compliance Framework 7. Performance Measurement Framework

Strategic Framework 2.

Organizational Framework

ASSET AND LIABILITY MANAGEMENT

6. Information Reporting Framework

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1.

3.

Operational Framework

4.

Analytical Framework

5. Technology Framework ALM 2008

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Regulatory Environment – Risk Management Guidelines in India • ALM Guidelines - February,1999 • Operating Guidelines on Risk Management, October 7, 1999 covering broad contours for management of credit, liquidity, interest rate, foreign exchange and operational risks. • December 2000 : Capital Adequacy Guidelines for Primary Dealers covering Credit and Market Risk • On September 20, 2001, two Working Groups were constituted in Reserve Bank of India drawing experts from select banks and FIs for preparing detailed Guidance Notes on Credit Risk and Market Risk Management by banks.

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Risk Regulation in India • Identified further steps to be taken by banks for improving their existing risk management framework, suiting to Indian conditions • 2005 – Detailed Capital Adequacy guidelines for Banks to move towards Basel II, 2007- final guidelines • 2006 – April 17, the ALM framework of 1999 updated. • 2007- Pillar II guidelines being issued

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RBI revised guidelines 2007-08 • Issued on Sept 05, 2007 • Feb 10, 1999 guidelines covered Interest Rate and Liquidity Risk Management • Cumulative mis-matches in first bucket to be reported in Statement of Structural Liquidity • -ve Gap in 1-14 and 15-28 days buckets not to exceed 20 % of the cash flows • Need for revising this position – Hence revised the first bucket to 1, 2-7 & 8-14 days Com Bkg 2008

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RBI Revised ALM • Cumulative negative mismatches / Gap in new buckets – Next day, 2-7, 8-14 and 15-28 days not to exceed 5, 10, 15 and 20 % respectively of cash flow • Format of Statement of Structural Liquidity has been revised accordingly • Guidance instructions have been furnished • Banks given time to fine-tune MIS by 1 Jan’08 • Reporting frequency to continue as monthly • Supervision will be fortnightly – April 01,2008 • Financing of gaps above norms to be indicated Com Bkg 2008

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