Assets And Liability Management

Asset Liability Management in Banks

[Module A]

Live Interactive Learning Session- 30-11-2005

Presentation by S P Dhal, Faculty Member, SPBT College

Components of a Bank Balance sheet Liabilities

Assets

1. 2. 3. 4. 5.

1.

Capital Reserve & Surplus Deposits Borrowings Other Liabilities

2.

3. 4. 5. 6.

Cash & Balances with RBI Bal. With Banks & Money at Call and Short Notices Investments Advances Fixed Assets Other Assets

Contingent Liabilities

Components of Liabilities 1.Capital: Capital represents owner’s 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.

Components of Liabilities 2. Reserves & Surplus Components under this head includes: I. II. III. IV. V.

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

Components of Liabilities 3. Deposits This is the main source of bank’s funds. The deposits are classified as deposits payable on ‘demand’ and ‘time’. They are reflected in balance sheet as under: I. Demand Deposits II. Savings Bank Deposits III. Term Deposits

Components of Liabilities 4. Borrowings (Borrowings include Refinance / Borrowings from RBI, Inter-bank & other institutions) I. Borrowings in India i) Reserve Bank of India ii) Other Banks iii) Other Institutions & Agencies II. Borrowings outside India

Components of Liabilities 5. Other Liabilities & Provisions It is grouped as under: I. II. III. IV. V.

Bills Payable Inter Office Adjustments (Net) Interest Accrued Unsecured Redeemable Bonds (Subordinated Debt for Tier-II Capital) Others(including provisions)

Components of Assets 1. Cash & Bank Balances with RBI I. Cash in hand (including foreign currency notes) II. Balances with Reserve Bank of India In Current Accounts In Other Accounts

Components of Assets 2. BALANCES WITH BANKS AND MONEY AT CALL & SHORT NOTICE I. In India i) Balances with Banks a) In Current Accounts b) In Other Deposit Accounts ii) Money at Call and Short Notice a) With Banks b) With Other Institutions II. Outside India a) In Current Accounts b) In Other Deposit Accounts c) Money at Call & Short Notice

Components of Assets 3. Investments A major asset item in the bank’s balance sheet. Reflected under 6 buckets as under: I. Investments in India in : * i) Government Securities ii) Other approved Securities iii) Shares iv) Debentures and Bonds v) Subsidiaries and Sponsored Institutions vi) Others (UTI Shares , Commercial Papers, COD & Mutual Fund Units etc.) II. Investments outside India in ** Subsidiaries and/or Associates abroad

Components of Assets 4. Advances The most important assets for a bank. A. i) Bills Purchased and Discounted ii) Cash Credits, Overdrafts & Loans repayable on demand iii) Term Loans B. Particulars of Advances : i) Secured by tangible assets (including advances against Book Debts) ii) Covered by Bank/ Government Guarantees iii) Unsecured

Components of Assets 5. Fixed Asset I.

Premises

II.

Other Fixed Assets (Including furniture and fixtures)

6. Other Assets I.

Interest accrued

II.

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

III. IV. V. VI.

Contingent Liability Bank’s obligations under LCs, Guarantees, Acceptances on behalf of constituents and Bills accepted by the bank are reflected under this heads.

Banks Profit & Loss Account

• II.

A bank’s profit & Loss Account has the following components: Income: This includes Interest Income and Other Income. Expenses: This includes Interest Expended, Operating Expenses and Provisions & contingencies.

Components of Income 1. INTEREST EARNED I. II. III. IV.

Interest/Discount on Advances / Bills Income on Investments Interest on balances with Reserve Bank of India and other inter-bank funds Others

Components of Income 2. OTHER INCOME I. II. III. IV. V. VI. VII.

Commission, Exchange and Brokerage Profit on sale of Investments (Net) Profit/(Loss) on Revaluation of Investments Profit on sale of land, buildings and other assets (Net) Profit on exchange transactions (Net) Income earned by way of dividends etc. from subsidiaries and Associates abroad/in India Miscellaneous Income

Components of Expenses 1. INTEREST EXPENDED I. II. III.

Interest on Deposits Interest on Reserve Bank of India / Inter-Bank borrowings Others

Components of Expenses 2. OPERATING EXPENSES I. II. III. IV. V. VI. VII. VIII. IX. X. XI. XII.

Payments to and Provisions for employees Rent, Taxes and Lighting Printing and Stationery Advertisement and Publicity Depreciation on Bank's property Directors' Fees, Allowances and Expenses Auditors' Fees and Expenses (including Branch Auditors) Law Charges Postages, Telegrams, Telephones etc. Repairs and Maintenance Insurance Other Expenditure

Assets Liability Management It is a dynamic process of Planning, Organizing & Controlling of Assets & Liabilities- their volumes, mixes, maturities, yields and costs in order to maintain liquidity and NII.

Significance of ALM • • • •

Volatility Product Innovations & Complexities Regulatory Environment Management Recognition

Purpose & Objective of ALM An effective Asset Liability Management Technique aims to manage the volume, mix, maturity, rate sensitivity, quality and liquidity of assets and liabilities as a whole so as to attain a predetermined acceptable risk/reward ration. It is aimed to stabilize short-term profits, long-term earnings and long-term substance of the bank. The parameters for stabilizing ALM system are: 1. 2. 3.

Net Interest Income (NII) Net Interest Margin (NIM) Economic Equity Ratio

RBI DIRECTIVES • Issued draft guidelines on 10th Sept’98. • Final guidelines issued on 10th implementation of ALM w.e.f. 01.04.99.

Feb’99

for

• To begin with 60% of asset &liabilities will be covered; 100% from 01.04.2000. • Initially Gap Analysis to be applied in the first stage of implementation. • Disclosure to Balance Sheet on maturity pattern on Deposits, Borrowings, Investment & Advances w.e.f. 31.03.01

Liquidity Management Bank’s liquidity management is the process of generating funds to meet contractual or relationship obligations at reasonable prices at all times. New loan demands, existing commitments, and deposit withdrawals are the basic contractual or relationship obligations that a bank must meet.

Adequacy of liquidity position for a bank b. c. d. e. f. g. h. h.

Analysis of following factors throw light on a bank’s adequacy of liquidity position: Historical Funding requirement Current liquidity position Anticipated future funding needs Sources of funds Options for reducing funding needs Present and anticipated asset quality Present and future earning capacity and Present and planned capital position

Funding Avenues

b. c. d. e. e.

To satisfy funding needs, a bank must perform one or a combination of the following: Dispose off liquid assets Increase short term borrowings Decrease holding of less liquid assets Increase liability of a term nature Increase Capital funds

Types of Liquidity Risk • Liquidity Exposure can stem from both internally and externally. • External liquidity risks can be geographic, systemic or instrument specific. • Internal liquidity risk relates largely to perceptions of an institution in its various markets: local, regional, national or international

Other categories of liquidity risk • Funding Risk - Need to replace net outflows due to unanticipated withdrawals/non-renewal • Time Risk - Need to compensate for non-receipt of expected inflows of funds • Call Risk - Crystallization of contingent liability

Statement of Structural Liquidity All Assets & Liabilities to be reported as per their maturity profile into 8 maturity Buckets: i.

1 to 14 days

ii. 15 to 28 days iii. 29 days and up to 3 months iv. Over 3 months and up to 6 months v. Over 6 months and up to 1 year vi. Over 1 year and up to 3 years vii. Over 3 years and up to 5 years viii. Over 5 years

STATEMENT OF STRUCTURAL LIQUIDITY • Places all cash inflows and outflows in the maturity ladder as per residual maturity • Maturing Liability: cash outflow • Maturing Assets : Cash Inflow • Classified in to 8 time buckets • Mismatches in the first two buckets not to exceed 20% of outflows • Shows the structure as of a particular date • Banks can fix higher tolerance level for other maturity buckets.

An Example of Structural Liquidity Statement 15-28 1-14Days Days

Capital Liab-fixed Int Liab-floating Int Others Total outflow Investments Loans-fixed Int Loans - floating

300 200 350 400 50 50 700 650 200 150 50 50 200 150 Loans BPLR Linked 100 150 Others 50 50 Total Inflow 600 550 Gap -100 -100 Cumulative Gap -100 -200 -14.29 -15.38 Gap % to Total Outflow

30 Days- 3 Mths - 6 Mths - 1Year - 3 3 Years - Over 5 3 Month 6 Mths 1Year Years 5 Years Years

200 600 600 300 200 350 450 500 450 450 0 550 1050 1100 750 650 250 250 300 100 350 0 100 150 50 100 200 150 150 150 50 200 500 350 500 100 0 0 0 0 0 650 1000 950 800 600 100 -50 -150 50 -50 -100 -150 -300 -250 -300 18.18

-4.76

-13.64

6.67

-7.69

200 200 450 200 1050 900 100 50 100 200 1350 300 0 28.57

Total

200 2600 3400 300 6500 2500 600 1100 2000 300 6500 0 0

ADDRESSING THE MISMATCHES • Mismatches can be positive or negative • Positive Mismatch: M.A.>M.L. and Negative Mismatch M.L.>M.A. • In case of +ve mismatch, excess liquidity can be deployed in money market instruments, creating new assets & investment swaps etc. • For –ve mismatch,it can be financed from market borrowings (Call/Term), Bills rediscounting, Repos & deployment of foreign currency converted into rupee.

STRATEGIES… • To meet the mismatch in any maturity bucket, the bank has to look into taking deposit and invest it suitably so as to mature in time bucket with negative mismatch. • The bank can raise fresh deposits of Rs 300 crore over 5 years maturities and invest it in securities of 1-29 days of Rs 200 crores and rest matching with other out flows.

Maturity Pattern of Select Assets & Liabilities of A Bank Liability/Assets

I. Deposits a. Up to 1 year b. Over 1 yr to 3 yrs c. Over 3 yrs to 5 yrs d. Over 5 years 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 III. Loans & Advances a. Up to 1 year b. Over 1 yr to 3 yrs c. Over 3 yrs to 5 yrs d. Over 5 years Iv. Investment a. Up to 1 year b. Over 1 yr to 3 yrs c. Over 3 yrs to 5 yrs d. Over 5 years

Rupees (In Cr) 15200 8000 6700 230 270 450 180 00 150 120 8800 3400 3000 400 2000 5800 1300 300 900 3300

In Percentage

100 52.63 44.08 1.51 1.78 100 40.00 0.00 33.33 26.67 100 38.64 34.09 4.55 22.72 100 22.41 5.17 15.52 56.90

STATEMENT OF INTEREST RATE SENSITIVITY • Generated by grouping RSA,RSL & OFFBalance sheet items in to various (8)time buckets. RSA: • MONEY AT CALL • ADVANCES ( BPLR LINKED ) • INVESTMENT RSL • DEPOSITS EXCLUDING CD • BORROWINGS

MATURITY GAP METHOD (IRS) • • • •

THREE OPTIONS: A) RSA>RSL= Positive Gap B) RSL>RSA= Negative Gap C) RSL=RSA= Zero Gap

SUCCESS OF ALM IN BANKS : PRE - CONDITIONS 1. Awareness for ALM in the Bank staff at all levels–supportive Management & dedicated Teams. 2. Method of reporting data from Branches/ other Departments. (Strong MIS). 3. Computerization-Full computerization, networking. 4. Insight into the banking operations, economic forecasting, computerization, investment, credit. 5. Linking up ALM to future Risk Management Strategies.

Interest Rate Risk Management • Interest Rate risk is the exposure of a bank’s financial conditions to adverse movements of interest rates. • Though this is normal part of banking business, excessive interest rate risk can pose a significant threat to a bank’s earnings and capital base. • Changes in interest rates also affect the underlying value of the bank’s assets, liabilities and off-balance-sheet item.

Interest Rate Risk • Interest rate risk refers to volatility in Net Interest Income (NII) or variations in Net Interest Margin(NIM). • Therefore, an effective risk management process that maintains interest rate risk within prudent levels is essential to safety and soundness of the bank.

Sources of Interest Rate Risk • Interest rate risk mainly arises from: – – – – – – –

Gap Risk Basis Risk Net Interest Position Risk Embedded Option Risk Yield Curve Risk Price Risk Reinvestment Risk

Measurement of Interest Rate Risk • Gap Analysis- Simple maturity/re-pricing Schedules can be used to generate simple indicators of interest rate risk sensitivity of both earnings and economic value to changing interest rates. - If a negative gap occurs (RSARSL) in a given time band, an decrease in market interest rates could cause a decline in NII.

Measurement of Interest Rate Risk • Duration Analysis: Duration is a measure of the percentage change in the economic value of a position that occur given a small change in level of interest rate.

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