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ASSET LIABILITY MANAGEMENT IN BANKS (ALM)

What is ALM ? ALM is a comprehensive and dynamic framework for measuring, monitoring and managing the market risk of a bank. It is the management of structure of balance sheet (liabilities and assets) in such a way that the net earning from interest is maximised within the overall risk-preference (present and future) of the institutions. The ALM functions extend to liquidly risk management, management of market risk, trading risk management, funding and capital planning and profit planning and growth projection.
Benefits of ALM - It is a tool that enables bank managements to take business decisions in a more informed framework with an eye on the risks that bank is exposed to. It is an integrated approach to financial management, requiring simultaneous decisions about the types of amounts of financial assets and liabilities - both mix and volume - with the complexities of the financial markets in which the institution operates

The concept of ALM is of recent origin in India. It has been introduced in Indian Banking industry w.e.f. 1st April, 1999. ALM is 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 banks business strategy. Therefore, ALM is considered as an important tool for monitoring, measuring and managing the market risk of a bank. With the deregulation of interest regime in India, the Banking industry has been exposed to the market risks. To manage such risks, ALM is used so that the management is able to assess the risks and cover some of these by taking appropriate decisions. The assets and liabilities of the banks balance sheet are nothing but future cash inflows or outflows. With a view to measure the liquidity and interest rate risk, banks use of maturity ladder and then calculate cumulative surplus or deficit of funds in different time slots on the basis of statutory reserve cycle, which are termed as time buckets.
As a measure of liquidity management, banks are required to monitor their cumulative mismatches across all time buckets in their Statement of Structural Liquidity by establishing internal prudential limits with the approval of the Board / Management Committee.

The ALM process rests on three pillars: i. ALM Information Systems Management Information Systems Information availability, accuracy, adequacy and expediency ALM Organisation Structure and responsibilities Level of top management involvement ALM Process Risk parameters Risk identification Risk measurement Risk management Risk policies and tolerance levels.

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As per RBI guidelines, commercial banks are to distribute the outflows/inflows in different residual maturity period known as time buckets. The Assets and Liabilities wereearlier divided into 8 maturity buckets (1-14 days; 15-28 days; 29-

90 days; 91-180 days; 181-365 days, 1-3 years and 3-5 years and above 5 years), based on the remaining period to their maturity (also called residual maturity). All the liability figures are outflows while the asset figures are inflows. In September, 2007, having regard to the international practices, the level of sophistication of banks in India, the need for a sharper assessment of the efficacy of liquidity management and with a view to providing a stimulus for development of the termmoney market, RBI revised these guidelines and it was provided that (a) the banks may adopt a more granular approach to measurement of liquidity risk by splitting the first time bucket (1-14 days at present) in the Statement of Structural Liquidity into three time buckets viz., next day , 2-7 days and 8-14 days. Thus, now we have 10 time buckets. After such an exercise, each bucket of assets is matched with the corresponding bucket of the liabililty. When in a particular maturity bucket, the amount of maturing liabilities or assets does not match, such position is called a mismatch position, which creates liquidity surplus or liquidity crunch position and depending upon the interest rate movement, such situation may turnout to be risky for the bank. Banks are required to monitor such mismatches and take appropriate steps so that bank is not exposed to risks due to the interest rate movements during that period. (b) The net cumulative negative mismatches during the Next day, 2-7 days, 8-14 days and 15-28 days buckets should not exceed 5 % ,10%, 15 % and 20 % of the cumulative cash outflows in the respective time buckets in order to recognise the cumulative impact on liquidity. The Boards of the Banks have been entrusted with the overall responsibility for the management of risks and is required to decide the risk management policy and set limits for liquidity, interest rate, foreign exchange and equity price risks. Asset-Liability Committee (ALCO) is the top most committee to oversee the implementation of ALM system and it is to be headed by CMD or ED. ALCO considers product pricing for both deposits and advances, the desired maturity profile of the incremental assets and liabilities in addition to monitoring the risk levels of the bank. It will have to articulate current interest rates view of the bank and base its decisions for future business strategy on this view. Rate Sensitive Assets & Liabilities : An asset or liability is termed as rate sensitive when
(a) Within the time interval under consideration, there is a cash flow, (b) The interest rate resets/reprices contractually during the interval, (c) RBI changes interest rates where rates are administered and, (d) It is contractually pre-payable or withdrawal before the stated maturities. Assets and liabilities which receive / pay interest that vary with a benchmark rate are re-priced at pre-determined intervals and are rate sensitive at the time of re-pricing. INTEREST RISK : The phased deregulation of interest rates and the operational flexibility given to banks in pricing most of the assets and liabilities imply the need for the banking system to hedge the Interest-Rate Risk. Interest Rate Risk is the risk where changes in market interest rates might adversely affect the Banks Net Interest Income. The gap report should be generated by grouping interest rate sensitive liabilities, assets and off balance sheet positions into time buckets according to residual maturity or next repricing period, whichever is earlier. Interest rates on term deposits are fixed during their currency while the advance interest rates are floating rates. The gaps on the assets and liabilities are to be identified on different time buckets from 128 days, 29 days upto 3 months and so on. The interest changes should be studied vis-a-vis the impact on profitability on different time buckets to assess the interest rate risk.

GAP ANALYSIS : The various items of rate sensitive assets and liabilities and off-balance sheet items are classified into time buckets such as 1-28 days, 29 days and upto 3 months etc. and items non-sensitive to interest based on the probable date for change in interest. The gap is the difference between Rate Sensitive Assets (RSA) and Rate Sensitive Liabilities (RSL) in various time buckets. The positive gap indicates that it has more RSAS than RSLS whereas the negative gap indicates that it has more RSLS. The gap reports indicate whether the institution is in a position to benefit from rising interest rates by having a Positive Gap (RSA > RSL) or whether it is a position to benefit from declining interest rate by a negative Gap (RSL > RSA). REPORTS : The following reports are used for ALM:

Structual Liquidity Profile (SLP);

Interest Rate Sensitivity Maturity and Position (MAP)

Statement of Interest Rae Sensitivity (SIR)

------------------------------------------------------------------------------------------------------------------------------ASSET/LIABILITY MANAGEMENT (ALM) is one of the most important functions for achieving an optimal risk/reward trade-off in community banking, and its successful employment is the differentiating factor with regard to profitability among community banks. As much as we wish it were a science, ALM is the art of structuring a bank's balance sheet to take advantage of the current economic environment and anticipated changes in the economy, including movements in interest rates. For example, in January 2001, interest rates were expected to fall, and they did from 2001 to 2003, reaching the lowest levels experienced in 46 years. During 2003 and 2004, bankers managed assets and liabilities in an environment of 1% short-term interest rates and a 3% spread between the federal funds rate and the rate on the 10-year Treasury note with the expectation that rates would increase. The increase began in June 2004. The Fed increased the fed funds rate 425 basis points over two years. In 2007, interest rates are poised to fall and the economy is expected to weaken. It is this cycling of economic activity and interest rates that makes balance sheet management a challenge. ALM involves the ability to anticipate the above changes and to restructure the balance sheet to effectively neutralize possible threats and take advantage of potential opportunities. Being nimble is the secret to success. Too often, ALM is narrowly pigeonholed as market risk or interest rate risk management, when in reality these are only components of balance sheet management. Given its critical importance to an institution's success, ALM should be driven by the institution's strategic plan; that is, the strategic plan should provide the guidance for managing the balance sheet. Effective ALM must consider both profitability and risk. Very often, risk is viewed as the principal reason for ALM, but whether your institution is publicly owned, privately held, or a mutual association, ALM should incorporate the trade-off between risk and reward. ALM can be defined as the structuring of the balance sheet with the goal of achieving an optimal risk/ reward trade-off for your bank. The process must be profit driven. Therefore, ALM can be viewed as a process of managing the balance sheet to achieve an acceptable level of profitability while operating within regulatory risk parameters and a risk profile acceptable to the board of directors. Responsibilities and Roles ALM is not the sole responsibility of management, but rather a team effort between the board and management. That said, it is important to separate the responsibilities of each. The board has a responsibility to shareholders and regulators to establish policy and monitor the decisions of management. Management's role is to manage the balance sheet on a daily basis. This involves both the selection of earning assets and appropriate funding sources. Senior management is also responsible for managing balance sheet risk on an ongoing basis. The board is responsible for establishing parameters for balance sheet management. These parameters are usually included in the institution's loan, investment, and interest rate risk policies. Bank policies set the boundaries for managing risk. The board has the responsibility to monitor risk, but within the concept of risk management the board should ensure that management adheres to the policy guidelines. The committee responsible for managing the balance sheet is referred to as the ALCO. The committee's functions, makeup, agenda, and goals will be discussed below. The intent of the discussion is to suggest best practices, although there are situations and circumstances where a particular bank may choose a different approach. Irrespective of individual preferences, ALM and the functioning of the ALCO should be a systematic process based on consistency. What is the role of ALCO? The committee's job is to manage assets, liabilities, and capital along with managing balance sheet risk. In addition, the committee has the following responsibilities: * Manage the balance sheet to achieve an optimal balance between risk and reward. * Allocate cash and fund assets or manage liquidity. * Insulate the bank from interest rate risk. * Keep the board informed as to the total risk profile of the bank with a quarterly risk profile report. Prepare the board for audits by its primary regulator. In order to accomplish these responsibilities, the composition of the ALCO is important. This article focuses on a management ALCO, but many banks have a board ALCO. In establishing a board ALCO, three to five members are the suggested number, preferably individuals with some financial background. The management committee should encompass a wide range of senior management, but should at least include the following: * CEO--the top executive officer. * CFO--the senior financial officer, regardless of title, should provide the leadership for the committee. * Controller--this individual, along with the CFO, will be responsible for providing key information. * Investment officer--if the bank has a separate officer responsible for the investment portfolio.

* Senior loan officer--the committee will need to consider loan decisions in terms of volume and pricing. * Senior retail officer--the committee will need to make deposit decisions in terms of volume and price. Regardless of the size of your committee, it is important to have everyone focused on the critical issues related to balance sheet decisions. Those critical issues should be the focus of discussion and the foundation for decision making. Therefore, the key issues should provide the basis for a sound agenda. Sample ALCO Agenda 1. Macro Economy. Include a brief forecast of national trends and a discussion of the local impact that remains focused on the loan portfolio. This is where lenders can make a major contribution to the process, given that they probably have the best handle on the local economy. 2. Interest Rate Environment. Also include current short- and long-term interest rates, as well as a forecast for the next quarter. The diagram below represents the movement of short-term interest rates over the last eight years. The important issue for the committee is to come up with a consensus on the most likely direction of interest rates over the next quarter. [FIGURE 1 OMITTED] 3. Cash Flow Pro Forma. It is critically important to determine the bank's liquidity position. This can be best achieved with a cash flow pro forma. The diagram below presents a basic forecast of the sources and uses of cash. Sources Uses Nondiscretionary * Maturing investments * Investments called * Investment & loan amortization and prepayment Nondiscretionary * Mortgage pipeline * Loan commitments * Maturing deposits * Maturing or called borrowing

Scenario 1: Sources > Uses Scenario 2: Uses > Sources 4. Interest Rate Risk Exposure. A gap or simulation analysis is needed to determine if the bank is asset- or liability-sensitive. The diagram below reviews the relationship between balance sheet sensitivity and the change in interest rates. Rising Interest Falling Interest Rates Rates Asset Sensitivity Net interest margin increases! Net interest margin decreases!

Liability Net interest Net interest Sensitivity margin increases! margin decreases! 5. Loan and Deposit Activity. Loan and deposit activity versus budget. 6. Decisions. The committee is now ready to make decisions as to the deployment of cash and the funding of assets. The two broad decisions are categorized below based on the net forecasted cash flow. Scenario 1: Sources > Uses Scenario 2: Uses > Sources [right arrow] Deploy cash [right arrow] Fund assets Loan decisions Deposit decisions Investment decisions Borrowing decisions Pay off deposits Sell investments Repay borrowing Sell loans ALM's goal is to provide the bank with a stable and competitive return on assets, return on equity, or retained earnings. Risk reduces stability; therefore risk management is a key element in managing the balance sheet. The goals of the ALCO process are enumerated below and demonstrate the broad responsibilities of your committee. Earnings Growth One of the primary goals of ALM is to ensure earnings growth. A successful ALCO process should be able to engender positive growth in earnings in all interest rate environments. That said, the rate of growth may differ. For example, the rate of growth will likely decline for thrifts in a rising rate environment and for commercial banks in a falling rate environment. Positive growth should still remain the objective. anaging Balance Sheet Growth and Capital Maintenance Based on the strategic plan, the ALCO should manage balance sheet growth, blending the assets and liabilities in a way that will guarantee profitable growth. Liquidity management becomes an important consideration in balance sheet growth, and capital management is critical. Maintaining optimal capital ratios is best achieved through managing growth. Creating Stability ALCO is also tasked with achieving stable earnings. One of the committee's primary responsibilities is to maintain a stable net interest margin, resulting in stable net interest income. The stability of the net interest margin is best achieved through matching the re-pricing characteristics of assets and liabilities. Controlling Risk One of the board's primary responsibilities is setting risk limits and monitoring financial risk. Therefore, a primary responsibility of ALCO is risk management. The committee's principal focus is on liquidity and interest rate risk management. Effective

management of the balance sheet will reduce variance in earnings and capital over the interest rate risk cycle. The reduction in earnings and capital variation means less risk for the institution.

Conclusion
In summary, a balance sheet must be structured to generate a spread, which becomes the basis for profitability in community banking. The spread can be created through credit risk, interest rate risk, and core deposit strategies. The best performing community banks find an optimal blend of these determinants. Credit risk is usually a result of loan strategies, and the management of interest rate risk is an essential role for ALCO. The generation of core depositsis a blend of ALCO and marketing. Once structured, the balance needs to be managed attentively on a regular basis. The responsibility for ALM rests with ALCO and involves decision making with respect to loans and investments, as well as deposits and borrowing. The decision-making process is heavily influenced by external factors, including the economy, interest rates, accounting rulings, and regulatory policy. This article focused primarily on two critical areas of balance sheet management--liquidity and interest rate risk--because they are the major responsibilities of the ALCO. The key point is that the ALCO should be disciplined and have a formal structure best exemplified in the sample agenda. Contact James J. Clarke by e-mail at jjclarke2@aol.com. COPYRIGHT 2007 The Risk Management Association COPYRIGHT 2009 Gale, Cengage Learning