A PROJECT REPORT ON ASSET LIABILITY MANAGEMENT IN BANKS

SUBMITTED TO,

SHIVAJIRAO S. JONDHLE INSTITUTE OF MANAGEMENT SCIENCE & RESEARCH ASANGAON

UNDER THE GUIDANCE OF Prof. RENUKA DUBBANI

SUBMITTED BY, MAHESH R. KHEBADE (Roll no. 126) FINANCE

ACKNOWLEDGEMENT
Apart from my efforts, the success of this project depends largely on the encouragement and guidelines provided to me by our Banking and Insurance lecturer from time to time. I take this opportunity to express my gratitude to the person who has been instrumental in the successful completion of this project. I would like to shower our greatest appreciation to Prof. Renuka Dubbani under the guidance of whom, I felt motivated and encouraged to undertake this project.

Without her encouragement and guidance this project would not have materialized. I cant say thank you enough for her tremendous support and help. I am also grateful for every small effort she has put in to see to it that our project is a grand success.

I would also like to thank all those people who have directly or indirectly contributed to the successful completion of this project.

Thanking you all, for your kind anticipation in our project.

ASSET LIABILITY MANAGEMENT As financial intermediaries banks are known to accept deposit to lend money to entrepreneurs to make profit. They essentially intermediate between the opposing liquidity needs of depositors and borrowers. In the process, they function with an embedded mismatch between highly liquid liabilities on the one side and less liquid and long term assets on the other side of their balance sheets. Over and above this balance sheet conflict, they also stand exposed to a wide array of risk such as market risk, transformation risk, credit risk, liquidity risk, forex risk, legal risk, operation risk, reputational risk, interest rate risk, etc. The recognition of three main risk i.e. Interest Rate Risk, Liquidity Risk and Credit Risk gave rise to the concept of Asset Liability Management. Asset-Liability Management (ALM) can be termed as a risk management technique designed to earn an adequate return while maintaining a comfortable surplus of assets beyond liabilities. Banks are exposed to several risks which are multi-dimensional. The main direct financial risks are interest rate risk, liquidity risk, credit risk and market risk. 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. The asset-liability management function would involve planning, directing and controlling the flow, level, mix, cost and yield of the consolidated funds of the Bank. It takes into consideration interest rates, earning power, and degree of willingness to take on debt and hence is also known as Surplus Management. It enables banks to sustain their required growth rate by systematically managing market risk, liquidity risk, capital risk, etc. 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.

COMPONENTS OF FINANCIAL STATEMENT 3.1 Balance Sheet Liabilities 1. Capital: Capital represents owners 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 banks 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. 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 Purchased and Discounted, 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. For ALM these assets and liabilities are classified into different time periods called maturity buckets, depending on maturity profile and interest rate sensitivity. As per Reserve Bank of India guidelines issued for ALM implementation in bank in 1999, there are eight time buckets T-1 to T-8 classified respectively as follows: (i) 1 to 14 days (ii) 15 to 28 days (iii) Over 3 months and upto 6 months (iv) Over 6 months and upto 1 year (v) 1 year and upto 3 years (vi) 3years and upto 5 years (vii) Over 5 years 3.2 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.

RISK ASSOCIATED WITH ASSET LIABILITY MANAGEMENT Risk can be defined as the chance or the probability of loss or damage. In the case of banks these include credit risk, capital risk, market risk, interest rate risk, liquidity risk, operations risk and foreign exchange risks. These categories of financial risk require focus, since financial institutions like banks do have complexities and rapid changes in their operating environments. 1. Credit Risk: The risk of counter party failure in meeting the payment obligation on the specific date is known as credit risk. Credit risk management is an important challenge for financial institutions and failure on this front may lead to failure of banks. Credit risk plays a vital role in the way banks perform. It reflects the profitability, liquidity and reduced Non Performing Assets. The other important issue is contract enforcement. Legal reforms are very critical in order to have timely contract enforcement. Delays and loopholes in the legal system significantly affect the ability of the lender to enforce the contract. The legal system and its processes are notorious for delays showing scant regard for time and money that is the basis of sound functioning of the market system. Credit Risk Management is the process that puts in place systems and procedures enabling banks to:

Identify and measure the risk involved in credit proposition, both at individual transaction and portfolio level. Evaluate the impact of exposure on banks financial statements. Access the capability of the risk mitigates to hedge/insure risks. Design an appropriate risk management strategy to arrest risk mitigation.

2. Capital Risk: Capital risk is the risk an investor faces that he or she may lose all or part of the principal amount invested. It is the risk a company faces that it may lose value on its capital. The capital of a company can include equipment, factories and liquid securities. Capital adequacy focuses on the weighted average risk of lending and to that extent, banks are in a position to realign their portfolios between more risky and less risky assets. 3. Market Risk: Market risk refers to the risk to an institution resulting from movements in market prices, in particular, changes in interest rates, foreign exchange rates, and equity and

commodity prices. Market risk is also referred to as systematic risk. This risk cannot be diversified. Market risk is related to the financial condition, which results from adverse movement in market prices. This will be more pronounced when financial information has to be provided on a marked-to-market basis since significant fluctuations in asset holdings could adversely affect the balance sheet of banks. The problem is accentuated because many financial institutions acquire bonds and hold it till maturity. When there is a significant increase in the term structure of interest rates, or violent fluctuations in the rate structure, one finds substantial erosion of the value of the securities held. Market risk is often propagated by other forms of financial risk such as credit and market-liquidity risks. For example, a downgrading of the credit standing of an issuer could lead to a drop in the market value of securities issued by that issuer. Likewise, a major sale of a relatively illiquid security by another holder of the same security could depress the price of the security.

4. Interest Rate Risk: Banks in the past were primarily concerned about adhering to statutory liquidity ratio norms and to that extent they were acquiring government securities and holding it till maturity. But in the changed situation, namely moving away from administered interest rate structure to market determined rates, it becomes important for banks to equip themselves with some of these techniques, in order to immunize banks against interest rate risk. Interest risk is the change in prices of bonds that could occur as a result of change: n interest rates. In measuring its interest rate risk, an institution should incorporate re-pricing risk (arising from changing rate relationships across the spectrum of maturities), basis risk (arising from changing rate relationships among yield curves that affect the instituti ons activities) and optionality risks (arising from interest rate related options embedded in the institutions products). There are certain measures available to measure interest rate risk. These include:
Maturity:

Since it takes into account only the timing of the final principal payment, maturity

is considered as an approximate measure of risk and in a sense does not quantify risk. Longer maturity bonds are generally subject to more interest rate risk than shorter maturity bonds.

 Duration:

Is the weighted average time of all cash flows, with weights being the present

values of cash flows. Duration can again be used to determine the sensitivity of prices to changes in interest rates. It represents the percentage change in value in response to changes in interest rates.
Dollar

duration: Represents the actual dollar change in the market value of a holding of the

bond in response to a percentage change in rates.

Convexity:

Because of a change in market rates and because of passage of time, duration

may not remain constant. With each successive basis point movement downward, bond prices increase at an increasing rate. Similarly if rates increase, the rate of decline of bond prices declines. This property is called convexity.

5. Liquidity Risk: Liquidity Risk is the risk stemming from the lack of marketability of an investment that cannot be bought or sold quickly enough to prevent or minimize a loss. It is usually reflected in a wide bid-ask spread or large price movements. It arises from the potential inability of the Bank to generate adequate cash to cope with a decline in deposits or increase in assets. To a large extent, it is an outcome of the mismatch in the maturity patterns of assets and liabilities. There are two types of liquidity i.e. market liquidity and funding liquidity. Liquidity risk broadly comprises three sub-types:

Funding Risk: The need to replace net outflows of funds whether due to withdrawal of retail deposits or non-renewal of wholesale funds.

Time Risk: The need to compensate for non-receipt of expected inflows of funds, e.g. when a borrower fails to meet his repayment commitments.

Call Risk: The need to find fresh funds when contingent liabilities become due. Call risk also includes the need to be able to undertake new transactions when desirable.

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, subcommittees, 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 Value-atRisk 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 recipients 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.

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.

THREE PILLARS OF ALM The three pillars of Asset-Liability Management are as follows: 1. ALM Information Systems 2. ALM Organization 3. ALM Process Pillar 1: ALM Information System It includes Management Information System, Information availability, accuracy, adequacy and expediency. A good information system gives the bank management a complete picture of the bank's balance sheet. Considering the large network of branches and the lack of an adequate system to collect information required for ALM which analyses information on the basis of residual maturity and behavioral pattern it will take time for banks in the present state to get the requisite information. The problem of ALM needs to be addressed by following an ABC approach i.e. analyzing the behavior of asset and liability products in the top branches accounting for significant business and then making rational assumptions about the way in which assets and liabilities would behave in other branches. In respect of foreign exchange, investment portfolio and money market operations, in view of the centralized nature of the functions, it would be much easier to collect reliable information. The data and assumptions can then be refined over time as the bank management gain experience of conducting business within an ALM framework. The spread of computerization will also help banks in accessing data. Pillar II: ALM Organization
The board should have overall responsibility for the management of risks and should decide the risk management policy of the bank and set the limits for liquidity, interest rate, foreign exchange and equity price risk. The responsibility of ALM is on the treasury department of the banks. The results of balance sheet analysis along with recommendations is place in Asset Liability Committee (ALCO) meeting by the treasurer where important decisions are made are made to minimize risk and maximize returns.

The Alco committee comprising of the senior management of bank is responsible for Balance Sheet risk management. The size of ALCO varies from organization to organization. CEO heads

the committee. The objective of the ALCO is to derive the most appropriate strategy for the banks in terms of the mix of assets and liabilities given its expectation for the future and the potential consequences of interest-rate movements, liquidity constraints, foreign exchange exposure and capital adequacy. It is the responsibility of the committee to ensure all strategies conform to the banks risk appetite and levels of exposure as determined by the Board Risk Committee. Pillar3: ALM Process The basic ALM processes involving identification, measurement and management of risk parameter .The RBI in its guidelines has asked Indian banks to use traditional techniques like Gap Analysis for monitoring interest rate and liquidity risk. However RBI is expecting Indian banks to move towards sophisticated techniques like Duration, Simulation, VaR in the future. For the accrued portfolio, most Indian Private Sector banks use Gap analysis, but are gradually moving towards duration analysis. Most of the foreign banks use duration analysis and are expected to move towards advanced methods.

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 vs floating rate funds, wholesale vs retail deposits, money market vs capital market funding, domestic vs 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. 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

By invitation:

Economist Risk Consultants

TECHNIQUES OF ASEET LIABILITY MANAGEMENT

GAP Analysis Model:

Under the Gap analysis method, the various assets and liabilities are grouped under various time buckets based on the residual maturity of each item or the next repricing date, if on floating rate, whichever is earlier. Then the gap between the assets and liabilities under each time bucket is worked out. Since the objective is to maximize the NII, it will be sufficient if this is done only with respect to rate sensitive assets and liabilities. If the rate sensitive assets equal the rate sensitive liabilities, it is known as the Zero Gap or matched book position. If the rate sensitive assets are more than the rate sensitive liabilities, it is referred to as positive gap position and if the rate sensitive assets are less than the rate sensitive liabilities, it is known as negative gap position. The decision to hold a positive gap or a negative will depend on the expectation on the movement of interest rates. The effect of an upward movement or a downward movement in the interest rate on the NII will also depend on the position taken. These effects are given in the table below:
Changes in Interest Rates Increase Decrease Increase Decrease Increase Decrease Changes in Interest Income Increase Decrease Increase Decrease Increase Decrease Changes in Interest Expense Increase Decrease Increase Decrease Increase Decrease

GAP Position Positive Positive Negative Negative Zero Zero

Change in NII Increase Decrease Decrease Increase None None

Positive gap indicates a bank has more sensitive assets than liabilities and the NII will generally rise (fall) when interest rate rises (fall) Negative gap indicates a bank has more sensitive liabilities than assets and the NII will generally fall (rise) when interest rates rise (fall) It 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 and the bank's assets and the interest paid on its liabilities over a particular period of time. It is sometimes referred to as periodic gap because banks use gap analysis report to measure the interest rate sensitivity of RSA and RSL for different periods. These periods are known as maturity buckets which vary across banks, depending on the operating strategy.

Duration Analysis:

The Gap method ignores time value of money. . Under the duration method, the effect of a change in the interest rate on NII is studied by working out the duration gap and not the gap based on residual maturity. a. Timing and the magnitude of the cash flows is ascertained and calculated. b. By using appropriate discounting factor, the present value of each of the cash flows needs to be worked out. c. The time weighted value of the present value of the cash flows is calculates. d. The sum of the time weighted value of the cash flows divided by the sum of the present values will give the duration of a particular asset. Duration analysis is useful in assessing the impact of the interest rate changes on the market value of equity i.e. asset-liability structure.

Simulation Analysis:

It analyzes the interest-rate risk arising from both current and planned business. Gap analysis and duration analysis as stand-alone tool 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. What if:

The absolute level of interest rate shift There are non parallel yield curve changes Marketing plans are under-or-over achieved Margins achieved in the past are not sustained/improved Bad Debts and prepayment levels change in the different interest rate scenarios

There are changes in the funding mix e.g. an increasing reliance on short-term funds for balance sheet growth.

Accurate evaluation of current exposures of asset and liability portfolios to interest rate risk. Changes in multiple target variables such as NII, Capital adequacy and liquidity.

There are certain criteria for the 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 the managers might 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 the caution. The use of simulation model calls for commitment of substantial amount of time and resources. Value at Risk (VAR) Model:

Under VAR credit rating is given to each of the borrowers and its migration over the years form a part of the calculation of the credit value at risk over a given time horizon. This is due to credit risk, which emanates not only from counter party default, but also from slippage in credit quality. Thus, the volatility of value due to changes in the quality of the credit needs to be estimated to calculate VAR. In general; banks review financial statements of borrowers once a year and allot credit ratings. But there is no explicit theory to guide time horizon on risk assessment. Any risk assessment model shall normally predict relative risk than absolute risk. The objective of any risk assessment model is to initiate risk mitigating actions, irrespective of the time horizons. Hence, any risk measurement model can be tailored to suit different time horizons based on actual need.

BIBLIOGRAPHY

www.rbi.org

www.investopedia.com

www.allbankingsolutions.com

www.iibf.org.in

www.fimmda.org