Nisha 26-10-18.docx

“Asset

Liability Management in Banks” A Project Submitted to

University of Mumbai for partial completion of the degree of Master in Commerce Under the Faculty of Commerce By Nisha Popat Kamble

Under the Guidance of Meher Dhanatra R A Podar College of Commerce & Economics Matunga (East) Mumbai 400019

October 2018

1

“Asset

Liability Management in Banks” A Project Submitted to

University of Mumbai for partial completion of the degree of Master in Commerce Under the Faculty of Commerce By Nisha Popat Kamble

Under the Guidance of Meher Dhanatra R A Podar College of Commerce & Economics Matunga (East) Mumbai 400019

October 2018

2

Index Chapter No.

Title of the Chapter

Page No.

1

Introduction

5

2

Literature Review

7

3

Research Methodology

8

4

Executive Summary

9

5

Components Of Financial Statement

10

6

ALM in the Indian Banking Industry

13

7

ALM System in banks – RBI Guidelines

17

8

Risk Managed in ALM

19

9

Asset Liability Committee – ALCO

29

10

Process of ALCO

31

11

Elements of Asset Liability Management

32

12

Operations and Performance of Commercial Banks

36

13

Computation of performance measures

48

14

Findings of the study

51

15

Recommendations

52

16

Conclusion

53

17

References

54

18

Certificate

55

19

Declaration by learner

56

20

Acknowledgment

57

3

List Of Tables Sr No./Table No Particulars

Page No.

1

Generic Bank Risk Management Framework

15

2

Bank Within A Bank

16

3

Risk Managed In ALM

19

4

Interest Rate Risk

20

5

Process Of ALCO

31

6

Organization Structure Of ALCO

31

7

A Share Of CASA Deposits In Total Incremental

39

Deposits Declined 8

Borrowings Recorded Higher Growth

40

9

Consolidated International Claims Recorded Higher

42

Growth 10

ALM Extent And Persistence

43

11

Assets Liability Mismatches In The Indian Banking

45

Sector 12

Financial Performance Of Scheduled Commercial Banks

46

13

Movement In OBS & OBS Exposures And Balance Sheet

47

Assets 14

Efficiency Versus Profitability

47

15

Public Sector Bank

48

16

Private Sector Bank

49

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Introduction Asset Liability Management plays a important role in weaving together the different business lines in a financial institution. Manage liquidity and the balance sheet are crucial to the existence of a financial institution and sustenance of its operations. It is also imporatant for growth of the balance sheet in a profitable manner.

Asset Liability Management state management of all assets and liability of a bank. It requires assessment of various types of risks and altering the asset liability portfolio to manage risk. Till the before 1990s, the RBI did the real banking business and commercial banks were executors of what RBI decided. But now, Bureau of Indian Standard is standardizing the practices of banks all over the globe and India is part of this process. The concept of asset liability management is of recent origin in India. It has been introduced in Indian Banking industry with effect from. 1st April, 1999. Asset liability management is concerned for risk management and provides a comprehensive and dynamic framework for measuring, monitoring and managing liquidity, interest rate, foreign exchange and equity and commodity price risks of a bank that needs to be closely involve with the banks’ business strategy.

In recent times, even large multinational financial institutions were in a deep liquidity crisis and in dire need of external intervention for survival. The practical importance of ALM and Liquidity Management had been underestimated. Also managements of large institutions, regulators, and observers saw how well-reputed firms and trusted institutions folded up and were not able to find a way out of the in depth liquidity crisis. This resulted in regulators attaching high importance to new measures needed to ensure a sound liquidity management system. Constently, regulators have increase and in some graphies, thoroughly revamped, regulatory observe on ALM and liquidity management.

ALM has gained significance in the financial services sector in recent years due to the some changes that have occurred in the post-liberalization period. There has been a big shift in the borrowers’ profile, the industry profile and the exposure limits for the same, interest rate structure for deposits and advances, and so on. This has been accompanied by increased imbalance of market, diversification of bank product profiles, and high competition between banks on a global scale, all adding to the risk of banks.

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Thus, banks highly needed to match the maturities of the assets and liabilities, balancing the objectives of profitability, liquidity, and risk. Now this end, the Bank of International Settlements has suggest a framework for the banks to grab the market risks that may be arise because of rate fluctuations and more credit risk. The Reserve Bank of India had implement the Basel II norms for the regulation of Indian banks, providing a framework for banks to develop ALM policies. An effective ALM technique aims to manage the mix, volume, maturity, maturity, quality and liquidity of the assets and liabilities as a globe so as to attain a pre-plan acceptable risks/price ratio. The aim of ALM is to increase the asset quality, the risks associated with the asset and liability and further manage them, in order to stable the short-term profits, the long-term earnings and the longterm live of the bank.

6

Literature Review

This is an analytical research study. The bank under study is ICICI Bank, Bank of Baroda, Punjab National Bank, HDFC, and Axis bank. The banks were selected as they have with a lot of policy changes after a lot of strategic moves. As a researcher wanted to know how this banks are managing and managing their assets and liabilities portfolios especially in the wake of various financial reforms, particularly relating to interest rate de-regulation. The secondary data was collected from the annual reports of all Banks, circulars and reading material on ALM. Period of the study is year 2016- 2017 respectively.

According to the news the Indian Financial System have changing and growing very fast way. Competitive business world involving both the asset and liabilities with changing interest rates as well as foreign exchange rates has brought pressure on the management of banks to maintain good profitability. Assets and Liability Management is a systematic and dynamic process of planning, organizing, coordinating and controlling the assets and liabilities or in the sense management of balance sheet structure in the bank is the biggest opportunity for the Indian banking system. The main objectives of the study is to understand the theoretical background of assets liability management and profile of the bank in general and to assess the performance of profitability position in ICICI Bank and also to evaluate the performance of profit and loss account and balance sheet ratios in ICICI Bank. In this data has been collected from secondary sources from annual reports of ICICI Bank from the period of 2013-14 to 201718. Finally to analyse the performance of assets and liabilities management has been measured it results the credit deposit ratio, quick ratio, interest expanded to interest earn, other income to total income and interest spread this ratio showing increasing fasion from one year to another year therefore the performance of assets liability management position is satisfactory and better in ICICI Bank.

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Research Methodology

 Type of research: The research methodology is descriptive in nature as it

involves fact-finding enquiries and reporting of what happened or what is going on currently.

 Data: Secondary data has being used for the analysis.

 Source of the secondary data: The source for the data is mainly the Centre for Monitoring Indian Economy Data. Other sources include Reserve Bank Of India publications, websites, Books and, News articles.

 Statistical Tools: The statistical tools used for the study and the analysis; include graphs, tables and ratios.

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Executive Summary

Asset Liability Management as a concept is slowly gaining importance in the Indian scenario. The ALM process in a bank is multidimensional in nature. It is the art of ensuring that the maturity profiles of assets match that of liabilities and combines the techniques of asset management, liability management and spread management into a joining process leading to an integrated management of the total balance sheet. The process of Asset Lability Management will differ from bank to bank and the success of the technique depends upon how effectively banks are able to forecast and manage the risks they taking and are expose to. Efficient liquidity and interest rate management are the two important activities of the banks and financial institutions in increasing their income while controlling the risk exposure. The deregulated interest rate environment has brought pressure on the management of banks to maintain a good balance among spreads, profitability and long-term viability. Since the last few years, there has been an high competition and banks have been required to take up strategic planning as an exercise for asset-liability management in order to survive and grow in the ever increasingly competitive and risks in environment. The Reserve Bank of India has implemented the Basel II norms for the regulation of Indian banks, providing a framework for banks to develop Asset Liability Management policies. The present study analyses asset-liability management in banks operating in India using the assetliability guidelines provided by the RBI. The primary objective of the study was to compare the maturity gaps in public, private and foreign banks in the Indian banking industry & How Asset Liability Management can be used as an important tool for managing liquidity risk and interest rate risk? ALM is based on three pillars and they are ALM Information System, ALM Organization and ALM Process. ALM brings to bear a holistic and futuristic perspective to the balance sheet management. Banks provide services that exposes them to various risks like credit risk, liquidity risk, interest rate risk to name a few. It is therefore appropriate for banks to focus on ALM when they face different types of risks. There are different techniques used by banks for Asset Liability Management and they are GAP analysis Model, Duration Gap analysis Model, Simulation Model and Value at Risk.

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Components of Financial Statement Balance Sheet

Liabilities

Assets

Capital

Cash & Bank Balances

Reserves & Surplus

Investments

Deposits

Advances

Borrowings

Fixed Assets

Other Liabilities & Provisions

Other Assets

Contingent Liabilities

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. 2. Reserves & Surplus: It includes Statutory Reserves, Capital Reserves, Investment Fluctuation Reserve, Revenue and Other Reserves, Balance in Profit and Loss Account 3. Deposits: This is the main source of bank’s funds. The deposits are classified as deposits payable on ‘demand’ and ‘time’. This includes Demand Deposits, Savings Bank Deposits and Term Deposits 4. Borrowings: Borrowings include Refinance / Borrowings from RBI, Inter-bank & other institutions a) Borrowings in India i.e. Reserve Bank of India, Other Banks and Other Institutions & Agencies b) Borrowings outside India 5. Other Liabilities & Provisions: It can be grouped as Bills Payable, Interest Accrued, Unsecured redeemable bonds, and other provisions

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Assets 1. Cash & Bank Balances: This includes cash in hand including foreign notes, balances with Reserve Bank of India in current and other accounts 2. Investments: This includes investments in India i.e. Government Securities, Other approved Securities, Shares, Debentures and Bonds, Subsidiaries and Sponsored Institutions, Others and investments abroad. 3. Advances: Bills Discounted and Purchase, Cash Credits, Overdrafts & Loans repayable on demand, Term Loans, Secured by tangible assets, Covered by Bank/ Government Guarantees. 4. Fixed Assets: This includes premises, land, furniture & fixtures, etc. 5. Other Assets: This includes Interest accrued, Tax paid in advance/tax deducted at source, Stationery and Stamps, Non-banking assets acquired in satisfaction of claims, Deferred Tax Asset (Net) and others.

Asset Repayment Inflows into Banks Cash Bank Balance

1 - 14 Days Bucket Excess balance over required CRR SLR shown under 1 - 14 Days Bucket

Investments

Respective Maturity Buckets

Advances

Respective Maturity Buckets

other Assets

Respective Maturity Buckets

Asset Repayment Outflows from the Banks Capital Reserves & Surplus

Over 5 Years Bucket Over 5 Years Bucket

Deposits

Respective Maturity Buckets

Borrowings

Respective Maturity Buckets

Other Liabilities and Provisions

Respective Maturity Buckets

Contingent Liabilities

Respective Maturity Buckets

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Contingent Liabilities Bank’s obligations under Letter of Credits, Guarantees, and Acceptances on behalf of constituents and Bills accepted by the bank are reflected under this heads. Profit and Loss Account Profit and Loss Account includes: Income 1. Interest Earned: This includes Interest/Discount on Advances / Bills, Income on Investments, Interest on balances with Reserve Bank of India and other inter-bank funds 2. Other Income: This includes Commission, Exchange and Brokerage, Profit on sale of Investments, Profit/ (Loss) on Revaluation of Investments, Profit on sale of land, buildings and other assets, Profit on exchange transactions, Miscellaneous Income. Expenses 1. Interest Expense: This includes Interest on Deposits, Interest on Reserve Bank of India / Inter-Bank borrowings and others. 2. Operating Expense: This includes Payments to and Provisions for employees, Rent, Taxes and Lighting, Printing and Stationery, Advertisement and Publicity, etc.

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ALM in the Indian Banking Industry

Its normal course, banks are exposed to credit and market risks in view of the asset-liability transformation. There has been a wide range of changes at a fast pace in the Indian financial markets due to its liberalisation Since last few years and growing integration of domestic markets with external markets. Therefore, the risks associated with bank’s operations have become complex and big, thus requires strategic management. Banks are now operating in a fairly deregulate environment and are required to determine on their own, interest rates on advance and deposits, in both foreign and domestic currencies on a fast basis. The interest rates on bank’s investments in other securities and government are now market related. Also, intense competition for business involve both the assets and liabilities together with increasing volatility in the domestic interest rates as well as foreign exchange rates, has brought pressure on the management of banks to maintain a good balance among spreads, profitability and long-term viability. Handling these pressures requires structured and comprehensive measures and not just ad hoc action. The Management of banks has to base their business decisions on a dynamic and integrated risk management system and process, driven by corporate strategy. Banks are exposed to several major risks in the course of their business including credit risk, interest rate risk, foreign exchange risk, equity/commodity price risk, liquidity risk and operational risks. Banks need to address these risks in a structured manner by upgrading their risk management and adopting a more comprehensive Asset-Liability Management (ALM) practices than has been done before by other procedures.

ALM, among other functions, is also concerned with risk management and provides a comprehensive and dynamic framework for measuring, monitoring and managing liquidity, interest rate, foreign exchange and equity and commodity price risks of a bank that needs to be closely integrated with the bank’s business strategy. It involves assessment of various types of risks and altering the asset-liability portfolio in a dynamic way in order to manage risks.

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For this very reason, in the year 1998, the Reserve Bank of India (RBI) forwarded guidelines for implementing ALM systems in banks. Based on the feedback received from various banks, the final guidelines were revised by the RBI, and implemented from the year 1999.

The objective of ALM is to manage risk and not eliminate it. Risks and rewards go hand in hand. One cannot expect to make huge profits without taking a huge amount of risk. The objectives do not limit the scope of the ALM functionality to mere risk assessment, but expanded the process to the taking on of risks that might conceivably result in an increase in economic value of the balance sheet. Apart from managing the risks ALM should enhance the net worth of the institution through opportunistic positioning of the balance sheet. The more leveraged an institution, the more critical is the ALM function with enterprise. The objectives of Asset-Liability Management are as follows: 

To protect and enhance the net worth of the institution.



Formulation of critical business policies and efficient allocation of Capital.



To increase the Net Interest Income (NII)



It is a quantification of the various risks in the balance sheet and optimizing of profit by ensuring acceptable balance between profitability, growth and risks.



ALM should provide liquidity management within the institution and choose a model that yields a stable net interest income consistently while ensuring liquidity.



To actively and judiciously leverage the balance sheet to stream line the management of regulatory capital.



Funding of banks operation through capital planning.



Product pricing and introduction of new products.



To control volatility of market value of capital from market risk.



Working out estimates of return and risk that might result from pursuing alternative programs.

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Generic Bank Risk Management Framework

A broad scope of what managing a balance sheet typically involves in a commercial bank.

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Bank within a Bank

Inflows and outflows pass through Group Treasury implying that ALM acts as the Bank within bank.

The various lines of business and the financial products offered within a financial institution invariably have a common touch point within the bank, as the Group Treasury and ALM are responsible for managing the cash flows within the institution. Viewed from an economic perspective, financial institutions are essential intermediaries that create and absorb liquidity in the financial system. The financial resources undergo a maturity transformation as they pass in and out of the bank. The maturity transformation is influenced by the market demand and supply, the policies and appetite of the financial institution and the market segments that the bank deals with. The process of financial and maturity transformation inevitably results in the financial institution undertaking significant maturity mismatch risk, interest rate risk and foreign exchange risk apart from credit risk. The core functions of ALM and Liquidity Risk Management enable financial institutions to manage and mitigate the risks within accepted levels. Notably, financial institutions are increasingly inclined to carry out this process profitably and seek to use optimal allocated capital.

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ALM System in banks – RBI Guidelines

Over the last few years the Indian financial markets have witnessed wide ranging changes at fast pace. Intense competition for business involving both the assets and liabilities, together with increasing volatility in the domestic interest rates as well as foreign exchange rates, has brought pressure on the management of banks to maintain a good balance among spreads, profitability and long-term viability. These pressures call for structured and comprehensive measures and not just ad hoc action. The Management of banks has to base their business decisions on a dynamic and integrated risk management system and process, driven by corporate strategy. Banks are exposed to several major risks in the course of their business credit risk, interest rate risk, foreign exchange risk, equity / commodity price risk, liquidity risk and operational risks. This note lays down broad guidelines in respect of interest rate and liquidity risks management systems in banks which form part of the Asset-Liability Management (ALM) function. The initial focus of the ALM function would be to enforce the risk management discipline viz. managing business after assessing the risks involved. The objective of good risk management programmes should be that these programmes will evolve into a strategic tool for bank management.

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The ALM process rests on three pillars:

1. ALM information systems

 Management Information System 

Information availability, accuracy, adequacy and expediency

2. ALM organization

 Structure and responsibilities 

Level of top management involvement

3. ALM process

 Risk parameters 

Risk identification



Risk measurement



Risk management



Risk policies and tolerance levels.

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Risk Managed in ALM

When we use the term “Risk”, we all mean financial risk or uncertainty of financial loss. If we consider risk in terms of probability of occurrence frequently, we measure risk on a scale, with certainty of occurrence at one end and certainty of non-occurrence at the other end. Risk is the greatest where the probability of occurrence or non-occurrence is equal. As per the Reserve Bank of India guidelines issued in Oct. 1999, there are three major types of risks encountered by the banks and these are Credit Risk, Market Risk & Operational Risk. Asset Liability Management essentially consists of managing the above referred to risks in an effective and efficient manner. The ALM function normally derives its charter from the Asset Liability Committee (ALCO) framework, which sets out the scope of the ALM function, the risk types that come under its purview and the acceptable levels of risk appetite. Though the primary focus of ALM is managing balance sheet risks, the ALM function increasingly tends to focus on balancing profitability while managing risks, and in the process pro-actively seeks to guard the bottom line and even maximize profitability.

The different types of risk encompassed in ALM and Liquidity Risk Management.

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A). Market Risk Market Risk may be defined as the possibility of loss to bank caused by the changes in the market variables. It is the risk that the value of on-/off-balance sheet positions will be adversely affected by movements in equity and interest rate markets, currency exchange rates and commodity prices. Market risk is the risk to the bank’s earnings and capital due to changes in the market level of interest rates or prices of securities, foreign exchange and equities, as well as the volatilities, of those prices. Market Risk Management provides a comprehensive and dynamic frame work for measuring, monitoring and managing liquidity, interest rate, foreign exchange and equity as well as commodity price risk of a bank that needs to be closely integrated with the bank’s business strategy. Scenario analysis and stress testing is yet another tool used to assess areas of potential problems in a given portfolio. Identification of future changes in economic conditions like – economic/industry overturns, market risk events, liquidity conditions etc that could have unfavourable effect on bank’s portfolio is a condition precedent for carrying out stress testing. As the underlying assumption keep changing from time to time, output of the test should be reviewed periodically as market risk management system should be responsive and sensitive to the happenings in the market.

1. Interest Rate Risk Financial institutions borrow and lend for different terms and maturity tenors. Apart from equity and retained earnings, the average maturity of borrowings and liabilities tend to be on the short to medium term buckets. On the asset side, the maturity tends to be across a broad range from overnight to as long as a home mortgage could run. A financial institution is normally required to participate in lending short, medium and long-terms depending on the nature of financial products on offer and what segment of the market the bank operates within.

Types of Interest Rate Risk

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Re-pricing Risk: The assets and liabilities could re-price at different dates and might be of a different tenor. For example, a loan on the asset side could re-price at three-monthly intervals whereas the deposit could be at a fixed interest rate or a variable rate, but re-pricing half-yearly. Even if the loan and deposit re-price similarly, the re-pricing dates do not synchronize.

Basis Risk: The assets could be based on LIBOR rates whereas the liabilities could be based on Treasury rates or a Swap market rate.

Yield Curve Risk: The yield curve has the potential to change at different points for differing terms. In other words, the changes are not always parallel but it could be a twist around a particular tenor and thereby affect different tenors differently.

Option Risk: The borrowers sometimes (or many times) have the ability to prepay their borrowings based on contractual terms and conditions. Loan contracts might have caps, floors, teaser rates, prepayment options and so on. Exercise of options impacts the financial institutions by giving rise to premature release of funds that have to be deployed in unfavourable market conditions and loss of profit on account of foreclosure of loans that earned a good spread.

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2. Credit Risk Credit Risk is the potential that a bank borrower/counter party fails to meet the obligations on agreed terms. There is always scope for the borrower to default from his commitments for one or the other reason resulting in crystallisation of credit risk to the bank. These losses could take the form outright default or alternatively, losses from changes in portfolio value arising from actual or perceived deterioration in credit quality that is short of default. Credit risk is inherent to the business of lending funds to the operations linked closely to market risk variables. The objective of credit risk management is to minimize the risk and maximize bank’s risk adjusted rate of return by assuming and maintaining credit exposure within the acceptable parameters. Credit risk consists of primarily two components, viz Quantity of risk, which is nothing but the outstanding loan balance as on the date of default and the quality of risk, viz, the severity of loss defined by both Probability of default as reduced by the recoveries that could be made in the event of default. Thus credit risk is a combined outcome of Default Risk and Exposure Risk. The element of Credit Risk is Portfolio risk comprising Concentration Risk as well as Intrinsic Risk and Transaction Risk comprising migration/down gradation risk as well as Default Risk. At the transaction level, credit ratings are useful measures of evaluating credit risk that is prevalent across the entire organization where treasury and credit functions are handled. Portfolio analysis help in identifying concentration of credit risk, default/migration statistics, recovery data, etc. In general, Default is not an abrupt process to happen suddenly and past experience dictates that, more often than not, borrower’s credit worthiness and asset quality declines gradually, which is otherwise known as migration. Default is an extreme event of credit migration. Off balance sheet exposures such as foreign exchange forward can tracks, swaps options etc are classified in to three broad categories such as full Risk, Medium Risk and Low risk and then translated into risk Neighed assets through a conversion factor and summed up. The management of credit risk includes a) measurement through credit rating/ scoring, b) Quantification through estimate of expected loan losses, c) Pricing on a scientific basis and d) Controlling through effective Loan Review Mechanism and Portfolio Management.

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A. Tools of Credit Risk Management. The instruments and tools, through which credit risk management is carried out, are detailed below: a) Exposure Ceilings: Prudential Limit is linked to Capital Funds – say 15% for individual borrower entity, 40% for a group with additional 10% for infrastructure projects undertaken by the group, Threshold limit is fixed at a level lower than Prudential Exposure; Substantial Exposure, which is the sum total of the exposures beyond threshold limit should not exceed 600% to 800% of the Capital Funds of the bank (i.e. six to eight times). b) Review/Renewal: Multi-tier Credit Approving Authority, constitution wise delegation of powers, Higher delegated powers for better-rated customers; discriminatory time schedule for review/renewal, Hurdle rates and Bench marks for fresh exposures and periodicity for renewal based on risk rating, etc are formulated. c) Risk Rating Model: Set up comprehensive risk scoring system on a six to nine point scale. Clearly define rating thresholds and review the ratings periodically preferably at half yearly intervals. Rating migration is to be mapped to estimate the expected loss. d) Risk based scientific pricing: Link loan pricing to expected loss. High-risk category borrowers are to be priced high. Build historical data on default losses. Allocate capital to absorb the unexpected loss. Adopt the RAROC framework. e) Portfolio Management: The need for credit portfolio management emanates from the necessity to optimize the benefits associated with diversification and to reduce the potential adverse impact of concentration of exposures to a particular borrower, sector or industry. Stipulate quantitative ceiling on aggregate exposure on specific rating categories, distribution of borrowers in various industry, business group and conduct rapid portfolio reviews. The existing framework of tracking the non-performing loans around the balance sheet date does not signal the quality of the entire loan book. There should be a proper & regular on-going system for identification of credit weaknesses well in advance. Initiate steps to preserve the desired portfolio quality and integrate portfolio reviews with credit decision-making process. f) Loan Review Mechanism: This should be done independent of credit operations. It is also referred as Credit Audit covering review of sanction process, compliance status, review of risk rating, and pick up of warning signals and recommendation of corrective action with the objective of improving credit quality. It should target all loans above certain cut-off limit ensuring that at least 30% to 40% of the portfolio is subjected to LRM in a year so as to ensure that all major credit risks embedded in the balance sheet have been tracked. This is done to bring about qualitative improvement in credit administration. Identify loans with credit weakness. Determine adequacy of loan loss provisions. Ensure adherence to lending policies and procedures. The focus of the credit audit needs to be broadened from account

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level to overall portfolio level. Regular, proper & prompt reporting to Top Management should be ensured.

B. Risk Rating Model Credit Audit is conducted on site, i.e. at the branch that has appraised the advance and where the main operative limits are made available. However, it is not required to risk borrowers’ factory/office premises. As observed by RBI, Credit Risk is the major component of risk management system and this should receive special attention of the Top Management of the bank. The process of credit risk management needs analysis of uncertainty and analysis of the risks inherent in a credit proposal.

3. Liquidity Risk Bank Deposits generally have a much shorter contractual maturity than loans and liquidity management needs to provide a cushion to cover anticipated deposit withdrawals. Liquidity is the ability to efficiently accommodate deposit as also reduction in liabilities and to fund the loan growth and possible funding of the off-balance sheet claims. The cash flows are placed in different time buckets based on future likely behaviour of assets, liabilities and off-balance sheet items. Liquidity risk consists of Funding Risk, Time Risk & Call Risk. Funding Risk: It is the need to replace net out flows due to unanticipated withdrawal/nonrenewal of deposit Time risk: It is the need to compensate for non receipt of expected inflows of funds, i.e. performing assets turning into nonperforming assets. Call risk: It happens on account of crystalisation of contingent liabilities and inability to undertake profitable business opportunities when desired. The Asset Liability Management (ALM) is a part of the overall risk management system in the banks. It implies examination of all the assets and liabilities simultaneously on a continuous basis with a view to ensuring a proper balance between funds mobilization and their deployment with respect to their a) maturity profiles, b) cost, c) yield, d) risk exposure, etc. It includes product pricing for deposits as well as advances, and the desired maturity profile of assets and liabilities.

4. Forex Risk Foreign exchange risk is the risk that a bank may suffer loss as a result of adverse exchange rate movement during a period in which it has an open position, either spot or forward or both in same foreign currency. Even in case where spot or forward positions in individual currencies are balanced the maturity pattern of forward transactions may produce mismatches. There is also a settlement risk arising out of default of the counter party and out of time lag in settlement of one currency in one center and the settlement of another currency in another time zone. Banks are also exposed to interest rate risk, which arises from the

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maturity mismatch of foreign currency position. The Value at Risk (VaR) indicates the risk that the bank is exposed due to uncovered position of mismatch and these gap positions are to be valued on daily basis at the prevalent forward market rates announced by FEDAI for the remaining maturities. Currency Risk is the possibility that exchange rate changes will alter the expected amount of principal and return of the lending or investment. At times, banks may try to cope with this specific risk on the lending side by shifting the risk associated with exchange rate fluctuations to the borrowers. However the risk does not get extinguished, but only gets converted in to credit risk.

5. Country Risk This is the risk that arises due to cross border transactions that are growing dramatically in the recent years owing to economic liberalization and globalization. It is the possibility that a country will be unable to service or repay debts to foreign lenders in time. It comprises of Transfer Risk arising on account of possibility of losses due to restrictions on external remittances; Sovereign Risk associated with lending to government of a sovereign nation or taking government guarantees; Political Risk when political environment or legislative process of country leads to government taking over the assets of the financial entity (like nationalization, etc) and preventing discharge of liabilities in a manner that had been agreed to earlier; Cross border risk arising on account of the borrower being a resident of a country other than the country where the cross border asset is booked; Currency Risk, a possibility that exchange rate change, will alter the expected amount of principal and return on the lending or investment. In the process there can be a situation in which seller (exporter) may deliver the goods, but may not be paid or the buyer (importer) might have paid the money in advance but was not delivered the goods for one or the other reasons.

B). Operational Risk Operational Risk is the risk of loss resulting from inadequate or failed internal processes, people and systems or external factors. In order to control this, the Bank primarily relies on its Internal Audit system. Furthermore, to monitor operational risk on an ongoing basis, the Bank has set up an Operational Risk Management Committee under the supervision of SubCommittee of Board on ALM and Risk Management. The Bank collects and analyses loss and near miss data on operational risk based on different parameters on a half yearly basis and takes corrective actions, wherever necessary.

C).Regulatory Risk When owned funds alone are managed by an entity, it is natural that very few regulators operate and supervise them. However, as banks accept deposit from public obviously better governance is expected of them. This entails multiplicity of regulatory controls. Many Banks, having already gone for public issue, have a greater responsibility and accountability. As banks deal with public funds and money, they are subject to various regulations.

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The very many regulators include Reserve Bank of India (RBI), Securities Exchange Board of India (SEBI), Department of Company Affairs (DCA), etc. Moreover, banks should ensure compliance of the applicable provisions of The Banking Regulation Act, The Companies Act, etc. Thus all the banks run the risk of multiple regulatory- risk which inhibits free growth of business as focus on compliance of too many regulations leave little energy and time for developing new business. Banks should learn the art of playing their business activities within the regulatory controls.

D).Environmental Risk As the years roll by and technological advancement takes place, expectation of the customers change and enlarge. With the economic liberalization and globalization, more national and international players are operating the financial markets, particularly in the banking field. This provides the platform for environmental change and exposes the bank to the environmental risk. Thus, unless the banks improve their delivery channels, reach customers, innovate their products that are service oriented, they are exposed to the environmental risk resulting in loss in business share with consequential profit.

ALM Core Functions - Managing Interest Rate Risk, Structural Gaps & Liquidity The ALM core function consists of managing maturity gaps and mismatches while managing interest rate risk within the overall mandate prescribed by ALCO. The key responsibilities and some typical actions initiated by the ALM team are dealt with in the following paragraphs: 1. Managing Structural Gaps In a financial institution with a mature ALM function, this is arguably the most critically and continuously monitored aspect, since the ALM Managers seek to manage the structural gaps in the Balance Sheet. While liquidity management focuses typically on short-term time ladders, the structural gap management shifts the focus on time ladders more than a year. This aspect of ALM stresses the importance of balancing maturities as well as cash flows on either side of balance sheet. It strategizes dynamically on balancing the gaps, issuing timely guidelines to adjust focus on ‘right’ product types and tenors, and actively involve ALCO in this process. a). Static Gap: The ALM function takes into consideration assets maturing in short, medium and long time ladders and seeks to balance it vis-à-vis liabilities maturing across short, medium and long term ladders. The gaps reports typically point to funding gaps and excess funds at different points in time. The challenge with the ALM function is that the gaps are dynamically evolving and need continuous monitoring as the balance sheet changes every day.

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b). Duration: Duration is considered as a measure of interest rate sensitivity. However, for our immediate purpose, let us set aside interest rate sensitivity. Macaulay’s duration is traditionally accepted as a good measure of ‘length’ of portfolio or a measure of centre of gravity of discounted cash-flows over life of an asset (or liability). It’s common practice to measure duration of portfolio for different product types as well as on an overall portfolio level. It’s useful to simulate how duration of portfolio will be affected by future events. c). Dynamic Gap: It is normal practice to rely on dynamic gap reports to simulate future gap positions for assumed business volumes and exercise of options (e.g., prepayments). In addition to proposed new volumes, prepayment transactions and assumed deposit roll-overs, the ALM manager would like to include a proposed hedge transaction. Let us assume that an international bank ABC averagely accumulates home loans to the tune of $50 MN in a month and the loans are predominantly linked to variable Swap Offer Rates (SOR). The bank likes to hedge its risk by entering into a swap transaction in order that it is less prone to vulnerable interest rates. The bank will enter into a $50 MN swap with another financial institution, so by design it receives SOR linked cash-flows and pays fixed as part of the swap transaction. In this case, our international bank ABC would like to visualize what its forecast gap positions and interest rate sensitive positions will look like assuming that it would enter into a swap transaction say, one month from now, by using a good ALM solution. d). Long-Term Assets / Long-Term Liabilities Ratio: ALM practitioners prefer to focus on the ratio of assets and liabilities exceeding one year and often want to set acceptable limits around this. Where there are operative limits, the ALCO meetings will usually monitor the ratio, and the institution constantly endeavours to stay within a comfortable level around this limit. This along with liquidity gaps help to bring in any imbalances and help maintain a structurally sound balance sheet. 2. Managing Interest Rate Sensitivity A financial institution typically relies on certain measures to evaluate and manage interest rate sensitivities. We deal with them below: a). Interest Rate Sensitivity Gap Reports: The ALM function seeks to monitor interest rate sensitivity by generating so-called interest rate sensitive gap reports, which provide a cash flow laddering based on re-pricing profile and frequency of interest rate sensitive assets and liabilities. b). Duration Measures: Modified duration seeks to measure net present value of a loan portfolio (or simply bond price) under different interest rate conditions. For example, one seeks to analyze by how much percentage the bond price will be affected by a basis point up and down move in interest rates. The resulting outputs help us determine the modified duration or simply interest rate sensitivity of the net present value or bond price.

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c). DV01 or PVBP: This one is arguably the most popular measure among ALM practitioners. DV01 seeks to calculate the dollar value by which the market value is affected by a basis point expected movement in the interest rates. It’s common to find leading banks setting internal limits around this measure to manage interest rate risk in the balance sheet. d). Net Interest Income (NII) Sensitivity: Financial institutions attach much importance to assessing the impact of interest rate changes, new business, change in product-mix and rollover of deposits on net interest income. Income statements that allow for comparison of net interest income under different scenarios are immensely helpful in understanding the impact of mild market movements and shocks on the income statement as well as balance sheet. 3. Managing Liquidity Typically, the ALM function seeks to generate daily gaps on short-term ladders and ensures that cumulative gaps operate within pre-set limits. Of course, managing liquidity gaps alone is not adequate. A well managed liquidity function will include liquidity contingency plan, liquid asset buffers and setting liquidity policies and limits in tune with level of risk that the management believes is acceptable and manageable. 4. ALCO Reporting In most banks, ALCO meets at pre-determined intervals and the agenda is usually predetermined. In order that ALCO meetings are effective, the ALCO pack (comprehensive in many cases) is distributed in advance and reviewed in the meeting. The reports include some of what is listed above and certain other reports. The ALCO function is critical to ALM function and serves as the reviewing and approving authority for several key decisions including balance sheet structure, gap analysis, capital adequacy ratios and above all pro-active management of Balance Sheet. 5. Funds Transfer Pricing (FTP) A healthy FTP mechanism is part of a healthy ALM solution FTP helps to ensure the demarcation between market risk and credit risk by passing on the appropriate cost of funds to respective owners of risk. In recent years, focus has been placed on not just the base FTP, but also on including FTP add-ons like liquidity premium and similar adjustments. Financial institutions appear to be reviewing their FTP practices including the basis for liquidity premium both as a result of process improvement and increasing regulatory interest.

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Asset Liability Committee – ALCO The Asset-Liability Committee (ALCO) consisting of the bank's senior management including CEO should be responsible for ensuring adherence to the limits set by the Board as well as for deciding the business strategy of the bank (on the assets and liabilities sides) in line with the bank's budget and decided risk management objectives. The ALM desk consisting of operating staff should be responsible for analyzing, monitoring and reporting the risk profiles to the ALCO. The staff should also prepare forecasts (simulations) showing the effects of various possible changes in market conditions related to the balance sheet and recommend the action needed to adhere to bank's internal limits. The ALCO is a decision making unit responsible for balance sheet planning from risk-return perspective including the strategic management of interest rate and liquidity risks. Each bank will have to decide on the role of its ALCO, its responsibility as also the decisions to be taken by it. The business and risk management strategy of the bank should ensure that the bank operates within the limits/parameters set by the Board. The business issues that an ALCO would consider, inter alia, will include product pricing for both deposits and advances, desired maturity profile of the incremental assets and liabilities, etc. In addition to monitoring the risk levels of the bank, the ALCO should review the results of and progress in implementation of the decisions made in the previous meetings. The ALCO would also articulate the current interest rate view of the bank and base its decisions for future business strategy on this view. In respect of the funding policy, for instance, its responsibility would be to decide on source and mix of liabilities or sale of assets. Towards this end, it will have to develop a view on future direction of interest rate movements and decide on a funding mix between fixed v/s floating rate funds, wholesale v/s retail deposits, money market vs capital market funding, domestic v/s foreign currency funding, etc. Individual banks will have to decide the frequency for holding their ALCO meetings. Top Management, the CEO/CMD or ED should head the Committee. The Chiefs of Investment, Credit, Funds Management/Treasury (forex and domestic), International banking and Economic Research can be members of the Committee. In addition the Head of the Information Technology Division should also be an invitee for building up of MIS and related computerization. Some banks may even have sub-committees.

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The size (number of members) of ALCO would depend on the size of each institution, business mix and organizational complexity. Committee composition Permanent members: 

Chairman



Managing Director/CEO



Financial Director



Risk Manager



Treasury Manager



ALCO officer



Divisional Managers



Economist



Risk Consultants

By invitation:

Purposes and Tasks of ALCO: 

Formation of an optimal structure of the Bank’s balance sheet to provide the maximum profitability, limiting the possible risk level;



Control over the capital adequacy and risk diversification;



Execution of the uniform interest policy;



Determination of the Bank’s liquidity management policy;



Control over the state of the current liquidity ratio and resources of the Bank;



Formation of the Bank’s capital markets policy;



Control over dynamics of size and yield of trading transactions (purchase/sale of currency, state and corporate securities, share, derivatives for such instruments) as well as extent of diversification thereof;



Control over dynamics of the basic performance indicators (ROE, ROA, Etc.) as prescribed in the Bank’s policy

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Process of ALCO

Organization Structure of ALCO

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Elements of Asset Liability Management There are nine elements related to ALM and they are as follows: 1. Strategic framework: The Board of Directors are responsible for setting the limits for risk at global as well as domestic levels. They have to decide how much risk they are willing to take in quantifiable terms. Also it is necessary to determine who is in chare of controlling risk in the organization and their responsibilities. 2. Organizational framework: All elements of the organization like the ALM Committee, sub–committees, etc., should have clearly defined roles and responsibilities. ALM activities should be supported by the top management with proper resource allocation and personnel committee. 3. Operational framework: There should be a proper direction for risk management with detailed guidelines on all aspects of ALM. The policy statement should be well articulated providing a clear direction for ALM function. 4. Analytical framework: Analytical methods in ALM require consistency, which includes periodic review of the models used to measure risk to avoid miscalculation and verifying their accuracy. Various analytical components like Gap, Duration, Stimulation and Valueat-Risk should be used to obtain appropriate insights. 5. Technology framework: An integrated technological framework is required to ensure all potential risks are captured and measured on a timely basis. It would be worthwhile to ensure that automatic information feeds into the ALM systems and he latest software is utilized to enable management perform extensive analysis, planning and measurement of all facets of the ALM function. 6. Information reporting framework: The information – reporting framework decides who receives information, how timely, how often and in how much detail and whether the amount and type of information received is appropriate and necessary for the recipient’s task. 7. Performance reporting framework: The performance of the traders and business units can easily be measured using valid risk measurement measures. The performance measurement considers approaches and ways to adjust performance measurement for the risks taken. The profitability of an institution comes from three sources: Asset, Liabilities and their efficient management.

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8. Regulatory compliance framework: The objective of regulatory compliance element is to ensure that there is compliance with the requirements, expectations and guidelines for risk – based capital and liquidity ratios. 9. Control framework: The control framework covers the control over all processes and systems. The emphasis should be on setting up a system of checks and balances to ensure the integrity of data, analysis and reporting. This can be ensured through regular internal / external reviews of the function.

Risk Measurement Techniques There are various techniques for measuring exposure of banks to interest rate risks:

Gap analysis model Measures the direction and extent of asset-liability mismatch through either funding or maturity gap. It is computed for assets and liabilities of differing maturities and is calculated for a set time horizon. This model looks at the repricing gap that exists between the interest revenue earned 9n the bank's assets and the interest paid on its liabilities over a particular period of time (Saunders, 1997). It highlights the net interest income exposure of the bank, to changes in interest rates in different maturity buckets.

Repricing gaps are calculated for assets and liabilities of differing maturities. A positive gap indicates that assets get repriced before liabilities, whereas, a negative gap indicates that liabilities get repriced before assets. The bank looks at the rate sensitivity (the time the bank manager will have to wait in order to change the posted rates on any asset or liability) of each asset and liability on the balance 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 rates impacting assets and liabilities in the relevant maturity bucket and GAP refers to the differences between the book value of the rate sensitive assets and the rate sensitive liabilities. Thus when there is a change in the interest rate, one can easily identify the impact of the change on the net interest income of the bank.

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Interest rate changes have a market value effect. The basic weakness with this model is that this method takes into account only the book value of assets and liabilities and hence ignores their market value. This method therefore is only a partial measure of the true interest rate exposure of a bank.

Duration model Duration is an important measure of the interest rate sensitivity of assets and liabilities as it takes into account the time of arrival of cash flows and the maturity of assets and liabilities. It is the weighted average time to maturity of all the preset values of cash flows. Duration basic -ally refers to the average life of the asset or the liability.

DP p = D (d R /1+R) The above equation describes the percentage fall in price of the bond for a given increase in the required interest rates or yields. The larger the value of the duration, the more sensitive is the price of that asset or liability to changes in interest rates. As per the above equation, the bank will be immunized from interest rate risk if the duration gap between assets and the liabilities is zero. The duration model has one important benefit. It uses the market value of assets and liabilities.

Value at Risk Refers to the maximum expected loss that a bank can suffer over a target horizon, given a certain confidence interval. It enables the calculation of market risk of a portfolio for which no historical data exists. It enables one to calculate the net worth of the organization at any particular point of time so that it is possible to focus on long-term risk implications of decisions that have already been taken or that are going to be taken. It is used extensively for measuring the market risk of a portfolio of assets and/or liabilities.

Simulation Simulation models help to introduce a dynamic element in the analysis of interest rate risk. Gap analysis and duration analysis as stand-alone too1 for asset-liability management suffer from their inability to move beyond the static analysis of current interest rate risk exposures. Basically simulation models utilize computer power to provide what if scenarios, for example: What if:

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 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 and improves the information available to management in terms of:  Accurate evaluation of current exposure of asset and liability portfolios to interest rate risk.  Changes in multiple target variables such as net interest income, capital adequacy, & liquidity.  Future gaps.

It is possible that the simulation model due to the nature of massive paper outputs may prevent us from seeing wood for the tree. In such a situation, it is extremely important to combine technical expertise with an understanding of issues in the organization. There are certain requirements for a simulation model to succeed. These pertain to accuracy of data and reliability of the assumptions made. In other words, one should be in a position to look at alternatives pertaining to prices, growth rates, 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 document their assumptions and data is not easily available for differential impacts of interest rates on several variables. Hence, simulation models need to be used with caution particularly in the Indian situation. Last but not the least the use of simulation models calls for commitment of substantial amount of time and resources. If we cannot afford the cost or, more importantly the time involved in simulation modelling, it makes sense to stick to simpler types of analysis.

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Operations and Performance of Commercial Banks The Indian banking sector performed better in 2010-11 over the previous year despite the challenging operational environment. The banking business of Scheduled Commercial Banks (SCBs) recorded higher growth in 2010-11 as compared with their performance during the last few years. Credit grew at 22.9 per cent and deposits grew at 18.3 per cent in 2010-11 over the previous year. Accordingly, the outstanding credit-deposit ratio of SCBs increased to 76.5 per cent in 2010-11 as compared with 73.6 per cent in the previous year. Despite the growing pressures on margins owing to higher interest rate environment, the return on assets (RoA) of SCBs improved to 1.10 per cent in 2010- 11 from 1.05 per cent in 2009-10. The capital to risk weighted assets ratio under both Basel I and II frameworks at 13.0 per cent and 14.2 per cent, respectively in 2010-11 remained well above the required minimum of 9 per cent. The gross NPAs to gross advances ratio declined to 2.25 per cent in 2010-11 from 2.39 per cent in 200910, displaying improvement in asset quality of the banking sector. Though there was improvement in the penetration of banking services in 2010-11 over the previous year, the extent of financial exclusion continued to be staggering. The number of complaints received at the Banking Ombudsman offices witnessed decline in 2010-11 over the previous year. Performance of banks was conditioned by the dynamics of growth-inflation trade-off The Indian banking sector, which is the edifice of the Indian financial sector, though weathered the worst consequences of the global financial turmoil to a large extent, had to traverse through a challenging macroeconomic environment during the post crisis period. Followed by the financial turmoil, the global financial sector was generally turbulent mainly because of the European sovereign debt crisis, and sluggish growth recovery in the Euro zone as also in the US. Banks operated in a challenging operational environment During 2010-11, higher interest rate environment not only caused concerns about slowdown in credit growth, but also increased the possibility of deterioration in asset quality on the back of the possible weakening of the repayment capacities of borrowers in general. The tight interest rate environment also affected the profit prospects of commercial banks due to the possibility of lower margins in 2010-11. During the year, the large credit intake by some of

36

the crucial sectors such as NBFCs and infrastructure, also raised concerns about financial soundness through the potential build up of sectoral credit booms. Large borrowings by the telecommunication companies to participate in the auction of 3G spectrum, reduction in Government spending as also the large currency holdings by the public due to high inflation made the liquidity conditions more stringent in 2010- 11. Consolidated balance sheet of SCBs registered higher growth The consolidated balance sheet of SCBs recorded higher growth in 2010-11 as compared with the previous year. This is in contrast to the trend observed during the last two years and signals a revival from the peripheral effects of global financial turmoil. The higher growth in the consolidated balance sheet of SCBs was contributed by all the bank groups except old private sector banks (OPRBs), which recorded marginal deceleration in growth. The highest growth was recorded by new private sector banks (NPRBs) followed by public sector banks (PSBs). Yet, as at end-March 2011, almost three fourths of the total assets of the banking sector belonged to PSBs followed by NPRBs (15 per cent). Old private sector banks had the lowest share (around four per cent) followed by foreign banks (FBs) (around seven per cent).

Liability side of the balance sheet was driven by capital, borrowings and, other liabilities On the liability side of the balance sheet, the growth was driven mainly by borrowings, capital, and other liabilities and provisions. The recapitalization of public sector banks by the Central Government, and the mobilization of funds from the stock market through public issues by PSBs were the main factors behind the growth of capital of SCBs in 2010-11. An interesting development about the consolidated balance sheet of SCBs in 2010-11 was the deceleration in the growth of savings bank deposits and demand deposits with a corresponding acceleration in the growth of term deposits. This could be due to the prevailing higher interest rate environment, making term deposits more attractive as compared with demand and savings deposits.

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Asset side of the balance sheet was driven by loans and advances On the asset side of the balance sheet, the growth was primarily driven by loans and advances. There was a revival in credit growth across all the bank groups except old private sector banks in 2010-11 as compared with the previous year despite the tight interest rate environment. Credit growth in 2010-11 of new private sector banks and foreign banks was particularly noteworthy when compared with their performance during the last year. Notably, the growth of investments of the banking sector witnessed deceleration in 2010-11 in comparison with the previous year. The only exception to this general trend was the new private sector banks, which recorded higher growth in investments in 2010-11 as compared with the previous year.

Major Liabilities of SCBs 1. Deposits: Deposits registered higher growth Deposits, which constitute 78 per cent of total liabilities of the banking sector registered higher growth in 2010-11 in contrast to the trend observed in the recent years. This was mainly because of the accelerated deposit mobilization of new private sector banks in 2010-11 over the previous year. The higher growth in deposits emanated mainly from term deposits. As alluded to earlier, this could be due to the higher interest rate environment leading to an increase in term deposit rates. While accelerated growth rate of term deposits is a welcome development from the point of view of stability of balance sheet as it strengthens the retail deposit base and reduces asset liability mismatches; it may increase the interest expenses of the banking sector, thus, adversely impacting profitability.

Share of CASA deposits in total incremental deposits declined

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In contrast, current account and savings account (CASA) deposits, which are least cost sources, recorded deceleration in 2010-11. It is pertinent to note that despite the increased remuneration on savings deposits based on a daily product basis with effect from April 1, 2010, the savings deposit mobilization decelerated in 2010-11 across all the bank groups as compared with the previous year. Shift of funds to term deposits due to higher interest rates is one of the reasons for this trend.

However, the upward revision in the savings deposit rate from 3.5 per cent to 4.0 per cent in April 2011 and deregulation of interest rate on savings deposits in October 2011, may improve the savings deposit mobilization going forward. However, in a competitive environment, with the deregulation of interest rates, savings deposits will no longer be as less expensive as they were in the past. In tune with the growth deceleration, the share of CASA deposits in total incremental deposits declined to 36 per cent in 2010-11 as compared with 48 per cent in the previous year. An analysis at the bank group level indicated that foreign banks had the highest share of CASA deposits followed by NPRBs and PSBs.

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2.

Borrowings: Borrowings recorded higher growth

Borrowings, which constitute nine per cent of the total liabilities of the banking sector recorded accelerated growth in 2010-11 as compared with the previous year. At the bank group level, the share of borrowings in total liabilities exhibited wide variation. The dependence of foreign banks and new private sector banks on borrowings was relatively high as compared with other bank groups (Chart IV.2).

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Major Assets of Scheduled Commercial Banks 1. Bank Credit: Growth of loans and advances witnessed acceleration It is interesting to note that despite the widespread concerns with regard to slowdown in credit off-take in the context of tight monetary policy, on a y-o-y basis, the loans and advances of the banking sector recorded higher growth in 2010-11 as compared with the previous year. While the economic recovery from the recent financial turmoil increased the demand for credit; from the supply side, higher growth in deposits as well as growth in capital facilitated higher credit growth. In contrast to the previous year’s trend, term loans grew at a higher rate in 2010-11 as compared with the previous year. In 2010-11, new private sector banks recorded significantly higher growth in term loans as compared with the previous year, on the back of corresponding high growth in term deposits mobilization. 2. Investments: Growth of investments decelerated Due to the accommodation of higher credit growth, there was an overall deceleration in the growth of investments in securities in 2010-11 as compared with the previous year. In 201011, almost three fourths of the total investments of the banking sector were in Government securities held in India, mainly to meet the SLR requirements prescribed by the Reserve Bank and to raise funds from the short term money market. However, investments of the banking sector in Government securities held in India recorded lower growth in 2010-11 as compared with the previous year in tune with the reduction in SLR requirements from 25 per cent to 24 per cent with effect from December 18, 2010. 3. Non-SLR investments declined The non-SLR investments of SCBs witnessed a decline in March 2011 as compared with those during the corresponding period of the previous year. This was primarily due to a decline in the investments in commercial paper in 2010-11 over those during the previous year. Investments in commercial paper are short-term investments of the banking sector to reap economic gain out of short-term surplus funds. The decline in such investments reflected tight liquidity conditions during 2010-11. On the other hand, banks’ investments in shares witnessed increase in 2010-11 over the previous year. Alongside, banks’ investments in

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bonds/ debentures also witnessed a marginal increase during 2010-11 as compared with the previous year.

International Liabilities and Assets of Scheduled Commercial Banks International liabilities registered moderated growth In 2010-11, international liabilities of the banking sector grew at a lower rate as compared with the growth in international assets. Yet, the international liabilities of the banking sector continued to be almost double of the international assets of the banking sector in 2010-11 as in the recent past. The growth in international liabilities was mainly led by growth in equities of banks held by non-residents, Non-Resident Ordinary (NRO) deposits and foreign currency borrowings. International assets recorded higher growth The growth in international assets was mainly led by foreign currency loans to residents, outstanding export bills drawn on non-residents by residents and Nostro balances.

Consolidated International Claims Consolidated international claims recorded higher growth The consolidated international claims of the banking sector registered higher growth in 201011 as compared with the previous year. The sector-wise composition of international claims showed that it was mainly claims on banks, which led the growth in total international claims of banks.

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Asset Liability Mismatches (ALM) in the Indian Banking Sector: The Extent and Persistence The analysis of the maturity profile of long-term assets and liabilities indicates that at the aggregate level, the long-term assets are financed by short-term liabilities. The ALM calculated as long-term assets minus long-term liabilities never turned out to be negative during the recent years implying that the higher growth observed in the long-term loan segment is leading to asset liability mismatches in the banking sector. Bucket-wise break-up of ALM positive gap shows that the banking sector has the highest ALM positive gap in the bucket more than five years followed by 3-5 years and 1-3 years. As at end-September 2010, ALM positive gap in the more than five years bucket constituted 42 per cent of the total ALM positive gap, followed by 3-5 years bucket (31 per cent) and 1-3 years bucket (27 per cent). An analysis of persistence of the positive ALM gap is carried out following the methodology developed by Marques (2004). Accordingly, the persistence of ALM positive gap is estimated on the basis of absence of mean reversion, that is

is used for testing the statistical significance of the measure of persistence γ.

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The value of γ for the ALM positive gap during the entire sample period, i.e., March 2006 to September 2010 for all SCBs is 0.47, which is slightly lower than 0.5. This indicates that there is no significant persistence in the ALM positive gap during the period under study at the aggregate level. The bucket-wise analysis of persistence shows that in none of the time buckets, the persistence is significant at five per cent level. However, at ten per cent level, it is persistent in the ‘one to three years’ time bucket. Thus, in sum, though at the aggregate level, the ALM positive gap is not significant, in the ‘one to three years’ bucket it is significant and calls for careful monitoring (Table). Almost 20 per cent of the long-term assets of the Indian banking sector were financed by shortterm liabilities in 2010-11. The percentage of long-term assets financed by short-term liabilities witnessed a marginal decline over the previous year. On the financing side, almost 23 per cent of short-term liabilities were used to finance almost 20 % of long-term assets in the banking sector. The percentage share of short term liabilities used to finance long-term assets also witnessed a marginal decline in 2010-11 over the previous year.

Off-Balance Sheet Operations of Scheduled Commercial Banks Off-balance sheet operations of banks continued to increase The recent global financial turmoil demonstrated the risk involved in accumulating large amount of off-balance sheet exposures (OBS). Recognizing the risky and uncertain nature of OBS, the Reserve Bank tightened the prudential norms on OBS in August 2008. The off-balance sheet exposures of the banking sector, which declined in the previous two years, witnessed a growth of 31 per cent in 2010-11. The forward exchange contracts constituted more than three fourths of total off-balance sheet exposures in 2010-11. The off balance sheet exposures of foreign banks constituted more than two thirds of the total offbalance sheet exposures of the banking sector in 2010-11.

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Asset Liability Mismatches in the Indian Banking Sector

Financial Performance of Scheduled Commercial Banks Profitability: Consolidated net profits recorded higher growth Despite widespread concerns with regard to profitability on account of higher interest expenses on the one hand and, higher nonperforming assets and the consequent higher provisioning requirements, and lower interest income on the other, the financial performance of SCBs improved in 2010-11 as compared with the previous year. The consolidated net profits of the banking sector recorded higher growth in 2010-11, in contrast to the deceleration experienced in 2009-10, primarily because of higher growth in interest income. The implementation of the Base rate system with effect from July 1, 2010, which prohibited sub-prime lending to the corporate sectors might have contributed to the higher interest income in 2010-11 apart from robust credit growth. Off-balance sheet exposures (OBS) raise concern as its exact impact on the soundness of the banking sector is uncertain. In the event of a default, the off-balance sheet exposures can seriously damage the soundness of the banking sector as demonstrated by the recent global financial turmoil. During the last ten years, the OBS of the banking sector witnessed substantial growth, especially that of new private sector banks and foreign banks. With the onset of the global financial turmoil, the policy on OBS was tightened in August 2008. Resultantly, there was a decline in OBS of the banking sector in 2008-09 and 2009-10.

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However, with the onset of recovery, OBS of the banking sector again witnessed a positive growth in 2010-11 (Chart A).

Growth of ‘other income’ decelerated ‘Other income’ recorded a lower growth in 2010-11 over the previous year. The decline in trading income of the banking sector in 2010-11 over the previous year was one of the reasons for this trend. However, despite the overall deceleration in ‘other income’, one of the major components of ‘other income’, viz., commission and brokerage recorded higher growth in 2010- 11 over the previous year. Operating expenses grew at a higher rate In contrast, the operating expenses of the banking sector grew at a higher rate in 2010-11 as compared with the previous year mainly on account of pay hikes implemented in the banking sector during the last one year. Further, provisions and contingencies also witnessed higher growth in 2010-11 as compared with the previous year, mainly on account of increase in gross non-performing assets (GNPAs) (in absolute terms). The depreciation in the value of investments owing to the higher interest rate environment also increased the provisioning requirements of the banking sector. As the provisioning requirements for various categories of NPAs were increased in May 2011, it is expected to increase further in future.

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Movement in OBS & OBS Exposures and Balance Sheet Assets – 2010 -11

Net Interest Margin of the Indian Banking Sector: Efficiency versus Profitability

The net interest margin (NIM), operating expenses and ‘other income’ are crucial in determining profitability of the banking sector. On the other side, one of the indicators, which is used to assess efficiency of the banking sector is NIM. NIM indicates the margin taken by the banking sector while doing banking business. In this context, there is a need to bring down NIM from an efficiency point of view, nevertheless, from a profitability point of view; there is a need to increase it. A balanced approach would be to bring down NIM, which will improve efficiency of financial intermediation, along with an increase in income from other sources and reduction in operating expenses to maintain profitability. In India, during the last one decade, NIM was in the range 2.5 per cent to 3.1 per cent. The NIM, which witnessed a declining trend during the period 2004 to 2010, improved during 2010-11. The NIM of the Indian banking sector continues to be higher than some of the emerging market economies of the world.

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Computation of performance measures The Net Interest Income (NII), Net Interest Margin (NIM), Net Income (NI) and gap are the measures used to gauge the performance of Bank with relation to the asset liability management. Net interest income = (Interest rate of RSA × Volume of RSA) + (Interest rate of FRA × volume of FRA) – (Interest rate of RSL × Volume of RSL) – (Interest rate of FRL × Volume of FRL)

Net interest margin =

Net interest income -------------------------------Total Performing Assets

Net Income = Net Interest Income – Provisions and contingencies

Comparison of Banks Using Ratio Analysis Public Sector Banks State Bank of India, Punjab National Bank & Bank of Baroda Profitability Ratios Interest Spread Adjusted Cash Margin(%) Net Profit Margin Return on Long Term Fund(%) Return on Net Worth(%) Adjusted Return on Net Worth(%) Return on Assets Excluding Revaluations Return on Assets Including Revaluations

48

SBI

PNB

BOB

4.12 9.6 8.55 96.72 12.71 12.74 1,023.40 1,023.40

4.67 15.39 14.56 108.49 22.12 22.11 632.48 678.91

4.6 18.16 17.18 89.23 20.2 20.2 536.16 536.16

Management Efficiency Ratios

SBI

PNB

BOB

8.39 4.1 0.09 4.29 2.67 1.43 0.65 0.14 8.48 4.29 0.08 7.24

8.87 4.35 0.19 4.52 2.41 2.05 1.32 0.14 9.06 4.52 0.09 6.04

7.5 3.39 0.25 4.11 1.7 1.86 1.33 0.12 7.75 4.11 0.08 5.25

SBI

PNB

BOB

Capital Adequacy Ratio Advances / Loans Funds(%) Debt Coverage Ratios Credit Deposit Ratio Investment Deposit Ratio Cash Deposit Ratio Total Debt to Owners Fund

11.98 77.19

12.42 78.98

14.52 78.56

79.9 33.45 8.96 14.37

76.25 30.75 7.49 15.62

73.87 24.24 6.11 14.55

Financial Charges Coverage Ratio

0.35

0.47

0.47

Financial Charges Coverage Ratio Post Tax Leverage Ratios Current Ratio Quick Ratio

1.19

1.31

1.34

0.04 8.5

0.03 22.24

0.02 26.38

HDFC

ICICI

AXIS

-18.28 16.12 60.12 15.6 15.7 549.97 549.97

-11.47 9.94 50.09 11.01 11.37 480.15 480.15

3.73 18.71 17.2 72.29 17.83 17.87 462.77 462.77

Interest Income / Total Funds Net Interest Income / Total Funds Non Interest Income / Total Funds Interest Expended / Total Funds Operating Expense / Total Funds Profit Before Provisions / Total Funds Net Profit / Total Funds Loans Turnover Total Income / Capital Employed (%) Interest Expended / Capital Employed (%) Total Assets Turnover Ratios Asset Turnover Ratio

Balance Sheet Ratios

Private Sector Banks Profitability Ratios Interest Spread Adjusted Cash Margin(%) Net Profit Margin Return on Long Term Fund(%) Return on Net Worth(%) Adjusted Return on Net Worth(%) Return on Assets Excluding Revaluations Return on Assets Including Revaluations

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Management Efficiency Ratios

HDFC Interest Income / Total Funds Net Interest Income / Total Funds Non-Interest Income / Total Funds Interest Expended / Total Funds Operating Expense / Total Funds Profit Before Provisions / Total Funds Net Profit / Total Funds Loans Turnover Total Income / Capital Employed(%) Interest Expended / Capital Employed(%) Total Assets Turnover Ratios Asset Turnover Ratio

9.89 6.12 -3.76 3.08 2.84 1.6 0.17 9.89 3.76 0.1 4.65

ICICI

AXIS

7.36 3.57 4.65 3.79 6.39 1.68 1.24 0.16 12 3.79 0.07 3.58

9.14 5.08 0.17 4.06 2.57 2.54 1.6 0.16 9.3 4.06 0.09 5.65

ICICI

AXIS

Balance Sheet Ratios

HDFC Capital Adequacy Ratio Advances / Loans Funds(%) Debt Coverage Ratios Credit Deposit Ratio Investment Deposit Ratio Cash Deposit Ratio Total Debt to Owners Fund

16.22 79.74

-65.63

12.65 76.16

76.41 34.29 10.81 8.14

91.58 79.09 9.8 4.69

74.65 38.71 7.07 9.96

Financial Charges Coverage Ratio

1.81

1.48

0.66

Financial Charges Coverage Ratio Post Tax Leverage Ratios Current Ratio Quick Ratio

1.48

1.35

1.43

0.06 6.79

0.1 3.26

0.02 19.6

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Findings of the study 1. PNB is better than other banks in regards to Profitability ratios. 2. For Management Efficiency Ratios: all banks are working hard and have more or less same ratios. 3. SBI is good at managing its assets & liability (current ratio) 4. Axis bank is high on Profits ratios, Asset Turnover Ratio, and Management Efficiency Ratios. 5. ICICI bank has high current ratio in comparison to other banks 0.1, where as HDFC is better at all other balance sheet ratios, because In ICICI Bank, interest rate risk is measured through the use of re-pricing gap analysis and duration analysis. ICICI Bank also uses interest rate derivatives to manage asset and liability positions. The bank is an active participant in the interest rate swap market and is one of the largest counterparties in India. 6. Public sector banks are doing better than private banks with all respects.

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Recommendations The two types of banks’ balance sheet risks include interest rate risk and liquidity risks. 

So their regular monitoring and managing is the need of the hour.



Banks should use the information about these risks as key input in their strategic business planning process.



While increasing the size of the balance sheet, the degree of asset liability mismatch should be kept in control. Because, the excessive mismatch would result in volatility in earnings.



Banks can also use sensitivity analysis for risk management purpose. It is found that the all bank are exposed to interest rate risk.

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Conclusion ALM was developed in the 1980s to help financial institutions control a sharp increase in interest rate risk. Subsequently, it evolved into a set of techniques that enable financial institutions to manage a much broader set of risks. ALM is likely to play a growing role in financial institutions going forward.

In the future, the management of interest rate risk will be more important to the performance of financial institutions. The removal of regulatory barriers, combined with a trend toward consolidation, has created larger and more complex institutions in need of more sophisticated risk management tools. Regulators and rating agencies are focusing increasingly on the risk management practices of the institutions they monitor. Finally, impressive technological progress in the capture, transfer, and processing of data has made sophisticated risk management techniques available to financial institutions.

The more bank managers will take advantage of these new developments to improve the transparency and flexibility of their business. In large part because they have adopted more systematic ALM, banks in developed markets offer more diverse and complex products than their emerging-market counterparts. An extension of that logic suggests that, even within developed markets, ALM could be an important determinant of bank product strategy

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References 1. RBI Guidelines on Asset Liability Management Practices in banks, http://www.rbi.org

2. Basel committee on banking supervision (2001). Principles for the management and supervision of interest rates risk, bank for international Settlements. 3. http://www.thehindu.com/business/Industry/article2755287.ece 4. http://www.adb.org/documents/reports/consultant/42096-reg/42096-reg-tacr.pdf 5. http://business-standard.com/india/news/rbi-again-warns-banksasset-liabilitymismatch/423227/ 6. Sinkey, J.F. (1992). Commercial bank financial management (4th ed). New York: Maxwell Macmillan International Edition. 7. Annual Report of Bank for the years, (2010 - 2011). 8. http://www.moneycontrol.com/competition/statebankindia/comparison/SBI 9. http://www.sify.com/finance/stockpricequote/State_Bank_of_IndiaSBI/balancesheet.html

10. http://www.rbi.org.in/scripts/PublicationsView.aspx?id=12976

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S.P. MANDALI’S

R. A. PODAR COLLEGE OF COMMERCE AND ECONOMICS MATUNGA, MUMBAI-400 019.

Certificate This is to certify that Ms/Mr has worked and duly completed her/his Project Work for the degree of Master in Commerce under the Faculty of Commerce in the subject of Advanced Financial Accounting and her/his project is entitled, “Asset Liability Management in Banks” under my supervision. I further certify that the entire work has been done by the learner under my guidance and that no part of it has been submitted previously for any Degree or Diploma of any University. It is her/ his own work and facts reported by her/his personal findings and investigations. Project Guide/Internal Examiner

External Examiner

Prof. _______________________

Prof.________________________

___________________ Dr. (Mrs.) Vinita Pimpale Course Co-ordinator

Date:

___________________ Dr. (Mrs.) Shobana Vasudevan Principal

Seal of the College

55

S.P. MANDALI’S

R. A. PODAR COLLEGE OF COMMERCE AND ECONOMICS MATUNGA, MUMBAI-400 019.

Declaration by learner I, the undersigned Miss. Nisha Popat Kamble declare that the work embodied in this project work hereby, titled “Asset Liability Management in Banks” , forms my own contribution to the research work carried out under the guidance of Meher Dhanatra is a result of my own research work and has not been previously submitted to any other University for any other Degree/ Diploma to this or any other University. Wherever reference has been made to previous works of others, it has been clearly indicated as such and included in the bibliography. I, here by further declare that all information of this document has been obtained and presented in accordance with academic rules and ethical conduct.

Name of the learner: Nisha Popat Kamble Signature: _________________________________

Certified by Name of the Guiding Teacher: Meher Dhanatra Signature: __________________________________

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Acknowledgment To list who all have helped me is difficult because they are so numerous and the depth is so enormous. I would like to acknowledge the following as being idealistic channels and fresh dimensions in the completion of this project. I take this opportunity to thank the University of Mumbai for giving me chance to do this project. I would like to thank my Principal, Dr. Mrs. Shobana Vasudevan for providing the necessary facilities required for completion of this project. I take this opportunity to thank our Coordinator Dr. Mrs. Vinita Pimpale, for her moral support and guidance. I would also like to express my sincere gratitude towards my project

guide

____________________ whose guidance and care made the project successful. I would like to thank my College Library, for having provided various reference books and magazines related to my project. Lastly, I would like to thank each and every person who directly or indirectly helped me in the completion of the project especially my Parents and Peers who supported me throughout my project.

Signature of the Student

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TABLE OF CONTENTS Executive Summary 2. 3.

Objective of the study Research Methodology

4.

Literature Review

5.

Benefits Of Asset Liability Management

6.

Introduction

7.

Components of Financial Statement

8.

ALM in the Indian Banking Industry

9.

Generic Bank Risk Management Framework

10.

Bank within a Bank

11.

ALM System in Banks – RBI Guidelines

12.

Risk Managed in ALM

13.

ALM Core Functions - Managing Interest Rate Risk, Structural Gaps & Liquidity

14.

Asset Liability Committee – ALCO

15.

Process of ALCO

16.

Organisation Structure of ALCO

17.

Elements of Asset Liability Management

18.

Risk Measurement Techniques

19.

Operations and Performance of Commercial Banks

20.

Asset Liability Mismatches (ALM) in the Indian Banking Sector: The Extent and Persistence

21.

Off-Balance Sheet Operations of Scheduled Commercial Banks

22.

Asset Liability Mismatches in the Indian Banking Sector

23.

Net Interest Margin of the Indian Banking Sector: Efficiency versus Profitability

24.

Computation of performance measures

25.

Comparison of Banks Using Ratio Analysis Public Sector Banks

26.

Private Sector Banks

27.

Findings of the study

28.

Recommendations

29.

Conclusion

30.

References

31.

Annexures

58

59