ASSET AND LIABILITY MANAGEMENT IN INDIAN BANKS: A STUDY OF SELECT BANKS Introduction: Asset-Liability Management (ALM) is concerned with

strategic management of assets and liabilities of banks, against risks caused by changes in the liquidity position of the bank, interest rates, and exchange rates, and against credit risk and contingency risk An effecti!e ALM technique aims to manage the !olume, mix, maturity, rate sensiti!ity, quality and liquidity of the assets and liabilities as a whole so as to attain a predetermined acceptable risk"reward ratio #he purpose of ALM is to enhance the asset quality, quantify the risks associated with the assets and liabilities and further manage them, in order to stabili$e the short-term profits, the long-term earnings and the long-run sustenance of the bank #he importance of Asset Liability Management in %ndian &anks is growing at a rapid pace %ndian &anks are now emphasi$ing more on Asset Liability Management as a means of sound financial management of &anking 'perations #he (eser!e &ank of %ndia ((&%) has implemented the &asel %% norms for the regulation of %ndian banks which pro!ided a framework for banks to de!elop sound ALM policies #he present study analyses asset-liability management practices in %ndian banks in the context of guidelines pro!ided by the (eser!e &ank of %ndia Indian banking indu tr!: #he %ndian banking sector has emerged as one of the strongest dri!ers of %ndia)s economic growth #he banking system of %ndia should not only be hassle free but it should be able to meet new challenges posed by the technology and any other external and internal factors *ost %ndependence era, %ndia)s banking system has se!eral outstanding achie!ements to its credit #he most striking is its extensi!e reaches not only metropolitans or cosmopolitans but e!en to the remote corners of the country #his is one of the main reasons of %ndia)s growth process #he history of %ndian &anking +ystem can be segregated into three distinct phases #hey are as mentioned below, "#a $ I "r$%Nationa&i'ation $ra: -arly phase from ./01 to .212 of %ndian &anks "#a $ II Nationa&i'ation tag$: 3ationali$ation of %ndian &anks and up to .22. prior to %ndian banking sector (eforms "#a $ III "o t &ib$ra&i'ation $ra: 3ew phase of %ndian &anking +ystem with the ad!ent of %ndian 4inancial 5 &anking +ector (eforms after .22. and Liberali$ation

"#a $ I #he 6eneral &ank of %ndia was set up in the year ./01 #he -ast %ndia 7ompany established &ank of &engal (.082), &ank of &ombay (.098) and &ank of Madras (.09:) as independent units and called it *residency &anks #hese three banks were amalgamated in .2;8 and %mperial &ank of %ndia was established which started as pri!ate shareholders banks, mostly -uropeans shareholders %n .01< Allahabad &ank was established and first time exclusi!ely by %ndians, *un=ab 3ational &ank Ltd was set up in .029 with headquarters at Lahore &etween .281 and .2.:, &ank of %ndia, 7entral &ank of %ndia, &ank of &aroda, 7anara &ank, %ndian &ank, and &ank of Mysore were set up (eser!e &ank of %ndia came in .2:< >uring the first phase the growth was !ery slow and banks also experienced periodic failures between .2.: and .290 #here were approximately ..88 banks, mostly small #o streamline the functioning and acti!ities of commercial banks, the 6o!ernment of %ndia came up with #he &anking 7ompanies Act, .292 which was later changed to &anking (egulation Act .292 as per amending Act of .21< (Act 3o ;: of .21<) (eser!e &ank of %ndia was !ested with extensi!e powers for the super!ision of banking in %ndia as the 7entral &anking Authority >uring those day)s public has lesser confidence in the banks As an aftermath deposit mobili$ation was slow 3ot only that #he banks were selecti!e in in!iting the customers for transacting with tbe banks 'nly those wealthy and strong financial backgrounds were in!ited to be part of the clientele for the banks Abreast of it the sa!ings bank facility pro!ided by the *ostal department was comparati!ely safer Moreo!er, funds were largely gi!en to traders "#a $ II 6o!ernment took ma=or steps in this %ndian &anking +ector (eform after independence %n .2<<, it nationali$ed %mperial &ank of %ndia with extensi!e banking facilities on a large scale especially in rural and semi-urban areas %t formed +tate &ank of %ndia to act as the principal agent of (&% and to handle banking transactions of the ?nion and +tate 6o!ernments +e!en banks forming subsidiary of +tate &ank of %ndia was nationali$ed in .218 on .2th @uly, .212, ma=or process of nationali$ation was carried out %t was the effort of the then *rime Minister of %ndia, Mrs %ndira 6andhi .9 ma=or commercial banks in the country were nationali$ed +econd phase of nationali$ation %ndian &anking +ector (eform was carried out in .208 with se!en more banks #his step brought 08A of the banking segment in %ndia under 6o!ernment ownership #he following are the steps taken by the 6o!ernment of %ndia to (egulate &anking %nstitutions in the country,

.292, -nactment of &anking (egulation Act .2<<, 3ationali$ation of +tate &ank of %ndia .2<2, 3ationali$ation of +&% subsidiaries .21., %nsurance co!er extended to deposits .212, 3ationali$ation of .9 ma=or banks .2/., 7reation of credit guarantee corporation .2/<, 7reation of regional rural banks .208, 3ationali$ation of se!en banks with deposits o!er ;88 crore After the nationali$ation of banks, the branches of the public sector bank %ndia rose to approximately 088A in deposits and ad!ances took a huge =ump by ..,888A &anking in the sunshine of 6o!ernment ownership ga!e the public implicit faith and immense confidence about the sustainability of these institutions "#a $ III #his phase has introduced many more products and facilities in the banking sector in its reforms measure %n .22., under the chairmanship of M 3arasimham, a committee was set up by his name which worked for the liberali$ation of banking practices #he country is witnessed with the ad!ent of foreign banks and their A#M stations &anks started putting efforts to gi!e a satisfactory ser!ice to customers *hone banking and net banking was introduced #he entire system became more con!enient and swift #ime is gi!en more importance than money and the customer ser!ice has become the focal point of all banking operations #he financial system of %ndia has shown a great deal of resilience due to strong monetary policies and banking inno!ations #he public policy related to the economy as well as financial sector also added to the changing phase of banking system %t is sheltered from any crisis triggered by any external macroeconomics shock as other -ast Asian 7ountries suffered #his indicated the strength of the %ndian 4inancial +ystem of which &anking system is also a part %nno!ati!e financial management of &anks, Balue added ser!ices offered by the banks and focus on market orientation ha!e all added to the need for efficient management of banks to be competiti!e and to sur!i!e in the intense and dynamic financial system T#$ conc$(t o) ALM: ALM is a dynamic process of *lanning, 'rgani$ing, and 7ontrolling of Assets and Liabilities- their !olumes, mixes, maturities, yields and costs in order to maintain liquidity and 3et %nterest %ncome (3%%) ALM is about management of 3et %nterest Margin (3%M) to ensure that its le!el and risk factor are compatible with risk"return ob=ecti!es of the bank %t is more than =ust managing indi!idual assets and liabilities %t is an integrated approach to bank financial management requiring simultaneous decision about types and amount of financial assets
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and liabilities it holds or its mix and !olume %n addition, ALM requires an understanding of the market area in which the bank operates #he framework of asset-liability management broadly co!ers area of interest rate risk, liquidity risk, exchange risk and credit risk ALM can be defined as an operation for assessing the abo!e mentioned risks, acti!ely altering the asset-liability portfolio, and for strategically taking actions and managing risks with the ob=ecti!e of maximi$ing profits ALM is not limited to on balance sheet assets and liabilities such as deposits and lending)s only, but also includes off Cbalance sheet acti!ities such as swaps, futures and options #he ob=ecti!e of ALM is to make banks fully prepared to face the emerging challenges "ur(o $ and ob*$cti+$ o) ALM: (e!iew the interest rate structure and compare the same to the interest"product pricing of both assets and liabilities -xamine the loan and in!estment portfolios in the light of the foreign exchange risk and liquidity risk that might arise -xamine the credit risk and contingency risk that may originate either due to rate fluctuations or otherwise and assess the quality of assets (e!iew, the actual performance against the pro=ections made and analy$es the reasons for any effect on spreads Aim is to stabili$e the short-term profits, long-term earnings and long-term substance of the bank #he parameters that are selected for the purpose of stabili$ing asset liability management of banks are, -3et %nterest %ncome (3%%) -3et %nterest Margin (3%M) --conomic -quity (atio T#$ N$c$ it! o) A $t Liabi&it! Manag$,$nt in Indian bank ALM is introduced in %ndian &anking industry from .st April, .222 ALM is concerned with risk management and pro!ides a comprehensi!e and dynamic frame work for measuring, monitoring and managing liquidity, interest rate, foreign exchange and equity and commodity price risks of a bank that needs to be closely integrated with the banks business strategy #he asset-liability management in the %ndian banks is still in its nascent stage Dith the freedom obtained through reform process, the %ndian banks ha!e reached greater hori$ons by exploring new a!enues #he go!ernment ownership of most banks resulted in a carefree attitude towards risk management #his complacent beha!ior of banks forced the (eser!e &ank to use regulatory tactics to ensure the implementation of the ALM Also, the post-reform banking scenario is marked by interest rate deregulation, entry of new pri!ate banks, and gamut of new products and greater use of information technology #o cope with these pressures banks were required to e!ol!e strategies rather than ad hoc fire
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fighting solutions %mprudent liquidity management can put banks) earnings and reputation at great risk #hese pressures call for structured and comprehensi!e measures and not =ust contingency action #he Management of banks has to base their business decisions on a dynamic and integrated risk management system and process, dri!en by corporate strategy &anks are exposed to se!eral ma=or risks in the course of their business C credit risk, interest rate risk, foreign exchange risk, equity " commodity price risk, liquidity risk and operational risk %t is, therefore, important that banks introduce effecti!e risk management systems that address the issues related to interest rate, currency and liquidity risks I,(&$,$ntation o) ALM ! t$, %n .22:-29 (&% asked public sector banks to frame the ALM policy &ut, first e!er comprehensi!e circular for establishing ALM system was issued by (&% on .2 4eb, .222 According to this circular the process of ALM rest on : pillars . ALM %nformation systems Management %nformation +ystem %nformation a!ailability, accuracy, adequacy and expediency ; ALM 'rgani$ation +tructure and responsibilities Le!el of top management in!ol!ement : ALM *rocess (isk parameters (isk identification (isk measurement (isk management (isk policies and tolerance le!els ALM Organi'ation: #he Asset - Liability 7ommittee (AL7') consisting of the bankEs senior management including 7-' should be responsible for ensuring adherence to the limits set by the &oard as well as for deciding the business strategy of the bank (on the assets and liabilities sides) in line with the bankEs budget and decided risk management ob=ecti!es #he ALM desk consisting of operating staff should be responsible for analy$ing, monitoring and reporting the risk profiles to the AL7' #he staff should also prepare forecasts (simulations) showing the effects of !arious possible changes in market conditions related to the balance sheet and recommend the action needed to adhere to bankEs internal limits #he AL7' is a decision making unit responsible for balance sheet planning from risk return perspecti!e including the strategic management of interest rate and liquidity risks
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-ach bank will ha!e to decide on the role of its AL7' , its responsibility as also the decisions to be taken by it #he business and risk management strategy of the bank should ensure that the bank operates within the limits " parameters set by the &oard #he business issues that an AL7' would consider, inter alia, will include product pricing for both deposits and ad!ances, desired maturity profile of the incremental assets and liabilities, etc %n addition to monitoring the risk le!els of the bank, the AL7' should re!iew the results of and progress in implementation of the decisions made in the pre!ious meetings #he AL7' would also articulate the current interest rate !iew of the bank and base its decisions for future business strategy on this !iew %n respect of the funding policy, for instance, its responsibility would be to decide on source and mix of liabilities or sale of assets #owards this end, it will ha!e to de!elop a !iew on future direction of interest rate mo!ements and decide on a funding mix between fixed !s floating rate funds, wholesale !s retail deposits, money market !s capital market funding, domestic !s foreign currency funding, etc %ndi!idual banks will ha!e to decide the frequency for holding their AL7' meetings ALM In)or,ation S! t$,, ALM %nformation +ystem is used for the collection of information accurately, adequately and expeditiously %nformation is the key to the ALM process A good information system gi!es the bank management a complete picture of the bank)s balance sheet ALM "roc$ , #he basic ALM process in!ol!es identification, measurement and management of risk parameters #he (&% in its guidelines has asked %ndian banks to use traditional techniques like 6ap Analysis for monitoring interest rate and liquidity risk Fowe!er (&% is expecting %ndian banks to mo!e towards sophisticated techniques like >uration, +imulation, Ba( in the future Manag$,$nt o) -i k in ALM #he risk management is a complex function and it requires speciali$ed skills and expertise &anks ha!e been mo!ing towards the use of sophisticated models for measuring and managing risks Large banks and those operating in international markets should de!elop internal risk management models to be able to compete effecti!ely with their competitors As the domestic market integrates with the international markets, the banks should ha!e necessary expertise and skill in managing !arious types of risks in a scientific manner #he design of risk management functions of the bank dictated by the si$e, complexity of functions, the le!el of technical expertise and the quality of M%+ %nternationally adopted committee approaches for the risk management are the AssetLiability Management 7ommittee (AL7') deals with different types of market riskG the 7redit *olicy 7ommittee (7*7) o!ersees the credit"counterparty risk and country risk (isk can be defined as the chance or the probability of loss or damage %n the case of banks, these include credit risk, capital risk, market risk, interest rate risk and the liquidity risk +ince financial institutions like banks ha!e complexities and frequent changes in their operating en!ironments, these kinds of risks require more focus
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Mark$t -i k Manag$,$nt: Market risk refers to the uncertainty of future earnings resulting from changes in interest rates, exchange rates, market prices and !olatilities #he &ank assumes market risk from consumer and corporate loans, position taking, and trading and in!estment acti!ities #he strategy for controlling market risk shall in!ol!e, +tringent control and limits +trict segregation of front and back office duties >aily reporting of positions (egular independent re!iew of all controls and limits (igorous testing and auditing of all pricing, trading, risk management and accounting systems a. Trading -i k #he &ank conducts some trading acti!ities on behalf of its customers, but also trades for its own account #rading portfolios shall be managed with the intent to buy and sell financial instruments o!er a short period of time rather that hold positions for in!estments 7ontinued enhancement of the &ank)s trading risk management systems and processes will be kept up-to-date with market de!elopments #rading on behalf of customers will be done only for securities listed on the +ecurities -xchange, including bonds, treasury bills and shares +uch trading will be done by the &ank)s Licensed (epresentati!e under the super!ision of the Licensed *rincipal #here will be no limit for trades done on behalf of customers +ecurities, whether listed on the +ecurities -xchange or not, traded on the &ank)s own account will be traded by the &ank)s Licensed (epresentati!e under the super!ision of the Licensed *rincipal but will be authori$ed by the &ank)s officers in accordance with established in!estments limits >aily reports of profit and loss, limit o!erruns and compliance will be circulated to all appropriate departments and management for e!aluation (igorous analysis and testing programs will be applied to measure risk, and to !erify accuracy of !arious controls and limits #hese will include stress testing, and sensiti!ity analysis b. For$ign E/c#ang$ -i k #he operational currency of the &ank is the -7 >ollar Fowe!er, in order to meet customer needs, the &ank buys and sells a number of foreign currencies, holds assets and liabilities denominated in se!eral foreign currencies and also as a result of its in!estments in foreign currencies and its international trading acti!ities, the &ank recei!es income and pays expenses in foreign currency #he &ank is therefore exposed to foreign exchange risk associated with the effect of fluctuations in the rates of exchange in !arious
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currencies #o mitigate the risk of loss due to rate changes the &ank will match its positions as closely as possible Int$r$ t -at$ -i k ,anag$,$nt: #he function of ALM is not =ust protection from risk #he safety achie!ed through ALM also opens up opportunities for enhancing net worth %nterest rate risk (%(() largely poses a problem to a bank)s net interest income and profitability 7hanges in interest rates can significantly alter a bank)s net interest income (3%%), depending on the extent of mismatch between the asset and liability interest rate reset times 7hanges in interest rates also affect the market !alue of a bank)s equity, earnings, !alue of assets, liability, offbalance sheet items and cash flow Fence, the ob=ecti!e of interest rate risk management is to maintain earnings, impro!e the capability, ability to absorb potential loss and to ensure the adequacy of the compensation recei!ed for the risk taken and affect risk return trade-off Methods of managing %(( first require a bank to specify goals for either the book !alue or the market !alue of 3%% the focus will be on the current !alue of 3%% and latter on the market !alue of equity %n either case, though, the bank has to measure the risk exposure and formulate strategies to minimi$e or mitigate risk #he immediate focus of ALM is interest-rate risk and return as measured by a bank)s 3%M, 3%% 3%M H (3%%" -arning assets) 3%%H (%nterest income C %nterest expense) A bank)s 3%M, in turn, is a function of the interest-rate sensiti!ity, !olume, and mix of its -arning assets and liabilities #hat is, 3%M H f ((ate, Bolume, Mix) -ffects of interest rate risk 7hanges in interest rates can ha!e ad!erse effects both on a bank)s earnings and its economic !alue #he earnings perspecti!e, 4rom the earnings perspecti!e, the focus of analyses is the impact of changes in interest rates on accrual or reported earnings Bariation in earnings (3%%) is an important focal point for %(( analysis because reduced interest earnings will threaten the financial performance of an institution -conomic !alue perspecti!e, Bariation in market interest rates can also affect the economic !alue of a bank)s assets, liabilities, and 'ff &alance +heet ('&+) positions +ince the economic !alue perspecti!e considers the potential impact of interest rate changes on the present !alue of all future cash flows, it pro!ides a more comprehensi!e !iew of the potential long-term effects of changes in interest rates than is offered by the earnings perspecti!e #he economic !alue perspecti!e identifies risk arising from longterm interest rate gaps

-conomic Balue perspecti!e in!ol!es analy$ing the expected cash inflows on assets minus expected cash outflows on liabilities plus the net cash flows or off-balance sheet items &anking industry in %ndia has substantially more issues associated with interest rate risks, which is due to circumstances outside its control #his poses extra challenges to the banking sector '!er the time Asset-Liability Managers ha!e de!eloped a number of different ways to quantify the risk being taken #hese include, (i) (ii) (iii) Maturity, +ince it takes into account only the timing of the final principal payment, maturity is considered as approximate measure of risk and in a sense does not quantify risk >uration, is the weighted a!erage time of all cash flows, with weights being the present !alues of cash flows %t can again be used to determine the sensiti!ity of prices to change in interest rates 7on!exity, &ecause of a change in market rates and passage of time, duration may not remain constant Dith each successi!e basis point mo!ement downward, bond prices increases at an increasing rate +imilarly, if rate increase, the rate of decline of bond prices declines #his property is called con!exity

T#$ +ariou t!($ o) int$r$ t rat$ ri k ar$ id$nti)i$d a )o&&o0 : 6ap"Mismatch risk, %t arises from holding assets and liabilities and off balance sheet items with different principal amounts, maturity dates 5 re-pricing dates thereby creating exposure to unexpected changes in the le!el of market interest rates &asis (isk, %t is the risk that the %nterest rat of different Assets"liabilities and off balance items may change in different magnitude #he degree of basis risk is fairly high in respect of banks that create composite assets out of composite liabilities -mbedded option (isk, 'ption of pre-payment of loan and 4ore- closure of deposits before their stated maturities constitutes embedded option risk Iield cur!e risk, Mo!ement in yield cur!e and the impact of that on portfolio !alues and income (e price risk, Dhen assets are sold before maturities (ein!estment risk, ?ncertainty with regard to interest rate at which the future cash flows could be rein!ested 3et interest position risk, Dhen banks ha!e more earning assets than paying liabilities, net interest position risk arises in case market interest rates ad=ust downwards T$c#ni1u$ )or ,$a uring $/(o ur$ o) bank to int$r$ t rat$ ri k

%ndian banks use the con!entional gap reporting methodology for asset liability management for measuring interest rate risk from the earnings perspecti!e 6ap is the measurement of the difference between risk sensiti!e assets and risk sensiti!e liabilities Int$r$ t rat$ $n iti+it! and GA" ,anag$,$nt: #his model measures the direction and extent of asset-liability mismatch through a funding or maturity 6A* (or, simply, 6A*) Assets and liabilities are grouped in this method into time buckets according to maturity or the time until the first possible resetting of interest rates 4or each time bucket the 6A* equals the difference between the interest rate sensiti!e assets ((+As) and the interest rate sensiti!e liabilities ((+Ls) %n symbols, 6A* H (+As C (+Ls Dhen interest rates change, the bank)s 3%% changes based on the following interrelationships, J3%% H ((+As - (+Ls) x Jr J3%% H 6A* x Jr %nterrelationship between 6A* and J3%% +l no #ype of 6A* 7hange in interest rates 7hange (Jr) (J3%%)
(NII)NII

in

3%%

))((NII)

. ; : 9 < 1

(+A H (+Ls (+A H (+Ls (+As K (+Ls (+As K (+Ls (+As L (+Ls (+As L (+Ls

%ncrease >ecrease %ncrease >ecrease %ncrease >ecrease

3o 7hange 3o 7hange 3%% increases 3%% decreases 3%% decreases 3%% increases

Dhen (+AH(+L, 6A*H8G indicates A $ero 6A* will be the best interest- sensiti!e 6A* position either if the bank is unable to speculate interest rates accurately or if its capacity to absorb risk is close to $ero Dith a $ero 6A*, the bank is fully protected against both increases and decreases in interest rates as its 3%% will not change in both cases Dhen (+As K (+Ls, *ositi!e 6A*, Dhen (+As L (+Ls, 3egati!e 6A*, %n both the cases either 3%% may increase or decrease As a tool for managing %((, 6A* management suffers from three limitations, M 4inancial institutions in the normal course are incapable of out-predicting the markets, hence maintain the $ero 6A* M %t assumes that banks can flexibly ad=ust assets and liabilities to attain the desired 6A* M %t focuses only on the current interest sensiti!ity of the assets and liabilities, and ignores the effect of interest rate mo!ements on the !alue o bank assets and liabilities Cu,u&ati+$ GA" ,od$&
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%n this model, the sum of the periodic 6A*s is equal to the cumulati!e 6A* measured by the maturity 6A* model Dhile the periodic 6A* model corrects many of the deficiencies of the 6A* model, it does not explicitly account for the influence of multiple market rates on the interest income Duration GA" ,od$& 2DAGA"3 %n order to shift the bankEs focus to the economic !alue perspecti!e and to upgrade the ALM system, the duration gap analysis was suggested by the (eser!e &ank of %ndia ((&%) in its circular of ./ April ;881 Dith the margin for interest rates to fluctuate o!er time, and the need for banks to obtain expertise in handling management information systems (M%+), it would become necessary for banks to adopt an impro!ed ALM system and more sophisticated techniques such as the duration gap analysis >uration is defined as the a!erage life of a financial instrument %t also pro!ides an approximate measure of market !alue interest elasticity #he duration gap methodology should be implemented by calculating the modified duration of all assets and liabilities and the off-balance sheet items for a bank Fere, the weighted a!erage duration of assets and weighted a!erage duration of liabilities are used to measure the interest rate risk &anks need to compute the duration gap as prescribed by the (&% M >uration is a measure of percentage change in the economic !alue of a position that will occur gi!en a small change in the le!el of interest rates M >ifference between duration of assets and liabilities is bank)s net duration M %f >AN>L, a decrease in interest rate will increase the MB- of the bank M %f >LN>A, an increase in interest rate will increase the MB- of the bank and a decrease in interest rate will decrease the MB- of the bank M >uration 6ap Analysis recogni$es the time !alue of money M %t fails to recogni$e basis risk as it assumes parallel shift in yield cur!e >uration gap (>6A*) H Deighted a!erage modified duration of assets - Deight O Deighted a!erage modified duration of liabilities Dhere Deight H (isk sensiti!e liabilities"(isk sensiti!e assets Deighted a!erage duration of asset A. H Deight A. O MacaulayEs duration of asset A. Dhere Deight of an asset H Market !alue of asset ."Market !alue of total assets #otal weighted a!erage duration of assets H +um of weighted a!erage duration of indi!idual assets Deighted a!erage duration of liability A. H Deight A. O MacaulayEs duration of liability A. Dhere Deight of liability H Market !alue of liability ."Market !alue of total liabilities

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#otal weighted a!erage duration of liabilities H +um of weighted a!erage duration of indi!idual liabilities Modified duration of equity H >6A* x Le!erage Le!erage H (isk sensiti!e liabilities"-quity %f the duration of assets is greater than the duration of the liabilities, then a rise in the interest rate will cause the market !alue of equity to fall #he market !alue of equity denotes the long-term profits of a bank #he bank will ha!e to minimi$e unfa!orable mo!ement in this !alue due to interest rate fluctuations #he traditional gap method ignores how changes in interest rates affect the market !alue of the bankEs equity Si,u&ation ana&! i +imulations ser!e to construct the risk-return profile of the banking portfolio #his model helps to introduce a dynamic element in the analysis of interest rate risk +imulation models utili$e computer power to pro!ide DFA# %4 scenarios %t is !ery important to combine technical expertise with an understanding of issues in the organi$ation Accuracy of data and reliability of the assumption made are certain requirement for a simulation model to succeed +imulation technique attempts to o!ercome the limitation of 6A* and >uration approaches by computer modeling the bank)s interest rate sensiti!ity #he modeling makes assumptions about future path of interest rates, shape of yield cur!e, changes in business acti!ity, pricing and hedging strategies Li1uidit! and Fund Manag$,$nt: Liquidity is measured in terms of ha!ing sufficient funds a!ailable at all times, to meet fully and promptly, the legitimate demands for money made on the bank arising from deposit withdrawal, presentation of cheques, maturing in!estments, draws under committed loan facilities, and other financial commitments #he &ank needs to assure depositors that they can withdraw their funds when desired, borrowers of the a!ailability of funds to meet legitimate demands for credit expansion, and employees of the bank stability 5 longe!ity %t must be remembered howe!er that too much liquidity will ha!e a negati!e impact on profitability, while too little liquidity will increase the risk of insol!ency #he &ank is deemed to ha!e adequate liquidity when it can obtain sufficient cash promptly and at a reasonable rate (cost) #he determination of the adequacy of the &ank)s liquidity position depends upon an analysis of the &ank)s position relati!e to the following factors, historical funding requirements current liquidity position anticipated future funding needs present and anticipated asset quality
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 present and future earnings capacity sources of funds Li1uidit! -i k Liquidity risk is the risk of ha!ing to fund some assets by the acquisition of additional funds under unfa!orable market terms #his might occur when unexpected clearing drains occur in close proximity, when depositors are lea!ing the bank due to a perception of increased risk, or when loan growth is !ery strong Liquidity risk is the potential inability of a bank to meet its payment obligations in a timely and cost effecti!e manner %t arises when the bank is unable to generate cash to cope with a decline in deposits"liabilities or increase in assets #he Asset Liability Management (ALM) is a part of the o!erall risk management system in the banks %t implies examination of all the assets and liabilities simultaneously on a continuous basis with a !iew to ensuring a proper balance between funds mobili$ation and their deployment with respect to their a) maturity profiles, b) cost, c) yield, d) risk exposure, etc %t includes product pricing for deposits as well as ad!ances, and the desired maturity profile of assets and liabilities #olerance le!els on mismatches should be fixed for !arious maturities depending upon the asset liability profile, deposit mix, nature of cash flow etc &ank should track the impact of pre-payment of loans 5 premature closure of deposits so as to realistically estimate the cash flow profile #he liquidity risk in banks manifest in different dimensions, Funding -i k C %t is the need to replace net outflows due to unanticipated withdrawals"non-renewal of deposits (wholesale and retail) Ti,$ -i k C %t is the need to compensate for non-receipt of expected inflows of funds, i e performing assets turning into non-performing assetsG and Ca&& -i k C %t happens due to crystalli$ation of contingent liabilities and unable to undertake profitable business opportunities when desirable (&% recommended Asset liability management system for measuring cash flow mismatches at different time bands &anks should ha!e to analy$e the beha!ioral maturity profile of !arious components of on " off-balance sheet items on the basis of assumptions and trend analysis supported by time series analysis &anks should also undertake !ariance analysis, at least, once in six months to !alidate the assumptions #he assumptions should be fine-tuned o!er a period which facilitates near reality predictions about future beha!ior of on"off-balance sheet items

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(atios #he AL7' will monitor the &ankEs liquidity position by re!iewing the following measures, . 7ash reser!e Minimum 1A ; Liquid assets ;8A - ;1A : Loans">eposits /8A - 08A #he cash reser!e ratio is calculated by expressing cash reser!es (comprising local cash and net balances with the 7entral &ank) as a percentage of total deposits #he &anking Act requires that commercial banks hold 1A of their deposits with the 7entral &ank #he liquid assets ratio is calculated as liquid assets expressed as a percentage of total deposits, and the 7entral &ank guidelines pro!ide that this should be between ;8A and ;<A Liquid assets comprise total cash reser!es including foreign cash, treasury bills and other risk free in!estments, cheques held for collection and net balances with 7entral &ank and other banks #he loans to deposits ratio is calculated as net loans and ad!ances expressed as a percentage of deposits #he 7entral &ank prudential guidelines require a ratio between /<A and 0<A A !ery high ratio suggests a less liquid position and presents the risk that some loans may ha!e to be sold at a loss to meet depositors) claims A low ratio indicates excess liquidity and potentially low profits Funding: 4orecasting future e!ents is essential to adequate liquidity planning +ound financial management can help buffer negati!e changes in the &ank)s economic climate and accentuate positi!e ones 4orecasting of future e!ents is !ery sub=ecti!e and fraught with potential error Management must therefore de!elop contingency plans in case its pro=ections are wrong -ffecti!e contingency planning in!ol!es identifying minimum and maximum liability needs and weighing the alternati!e courses of action designed to meet the needs Monthly cash flow pro=ections will be sought from large customers #he following are alternati!e ways the &ank can meet its liquidity needs, %ncrease core (retail) deposits Acquire interbank deposits +ell large time or notice deposits in domestic money market &orrow from Lender of last resort (7entral &ank) &orrow on the %nter-&ank Market Lengthen the a!erage life of the bank)s liabilities portfolio Maintain unused lines of credit with other financial institutions Loan participations #he AL7' will re!iew annually, as part of the annual budget preparation, or as often as necessary, the &ank)s deposit structure in relation to !olume and trend of !arious types of
14

deposits, maturity distribution of time deposits and rates paid compared to rates offered by competitors In+$ t,$nt : %n!estments purchased will be consistent with a separate written in!estment policy #he ob=ecti!es of the in!estment policy are to (.) pro!ide liquidity (;) pro!ide for interest rate risk management, and (:) pro!ide additional profit #he in!estments portfolio shall be di!ersified to minimi$e the risk of loss resulting from o!er concentration of assets in specific class, currency, 7ountry, or economic sector #he &ank shall adopt a flexible weightings approach (strategic asset allocation) in!ol!ing the periodic ad=ustments of the weights for each category based either on the market analysis or on technical analysis (i e , market timing) A new allocation therefore may be constructed to capture greater returns in a changing market #he initial allocation is as follows,7lass %nitial Allocation 3ew Allocation +hort-term in!estments (Money Market) <<A 4ixed %ncome (&onds) 9<A -quities .<A Cr$dit -i k ,anag$,$nt, 7redit risk is the risk of loss resulting from the failure of a borrower or counterparty to honor its financial or contractual obligation 7redit risk arises both in the &ank)s direct lending operations and in its funding, in!estment and trading acti!ities, where counterparties ha!e repayment or other obligations to the &ank #he management of the &ank)s credit risk shall be consistent with separate written credit policies and procedures Cr$dit "o&ic! Ob*$cti+$ #he &ank)s credit policies will seek to achie!e the following ma=or ob=ecti!es, *ro!ision for loan losses " unsatisfactory assets C Maximum .8A 3et losses " a!erage loans - Maximum .A 7lassified non-performing loans " total loans - Maximum / <A Cr$dit "roc$ +ample &ank)s credit disciplines shall be based on a di!ision of authority, a committee system for dealing with all ma=or exposures, and periodic independent re!iew by the Audit >epartment &anking officers, who ha!e client contact, will de!elop and structure indi!idual proposals, and will appro!e credits within their indi!idual limits (etail credits will be assessed and authori$ed in branches within the criteria established by the &ank All proposals outside the officers) limits will be ad=udicated by the 7redit 7ommittee which will analy$e the financial strength of the customers and the risks inherent in the
15

proposals All exceptions to the credit policy of the &ank, or credits outside of the authority of the 7redit 7ommittee, must be referred to the -xecuti!e 7ommittee for its decision or recommendation to the &oard of >irectors Figher risk exposures are sub=ect to mandatory referral to the &oard of >irectors 7redit lines for off-balance sheet instruments such as credit card limits, letters of credit and guarantee, shall be managed as an integral part of the same process At least annually, banking officers will meet formally with each commercial client to re!iew their financial affairs and to assess the appropriateness of their credit requirements #he results will be formulated into a presentation which will be ad=udicated in the same manner as a new credit Dhere unusual risks exist, credits will be re!iewed more frequently %n this way, the &ank will remain fully aware of customers) risk profiles (isk ratings will be reassessed with each credit presentation or re!iew #o minimi$e risk the &ank will only accept those credits where there is reasonable confidence that the asset will be redeemed at face !alue Limits and maximum maturity periods for !arious types of loans will be outlined in the &ank)s 7redit *olicy

-i k Di+$r i)ication #he &ank)s credit policies and limits are intended to ensure broad di!ersification across !arious types of credit risk Limits will be set for indi!idual borrowers, particular industries and certain types of lending #here !arious risks will be determined taking into account the relati!e risk of the borrower, economic acti!ity or product type "ricing )or -i k #he &ank will classify loans into risk categories by economic sector and by product and will price the loans to compensate for the risk in!ol!ed Accounting )or "rob&$, Loan #he &oard of >irectors understands that in any portfolio there will be delinquent loans which require special accounting procedures #he &ank has therefore adopted the 7entral &ank *rudential 6uidelines with respect to loan re!iew, loan classification, loan pro!isioning, and suspension of interest and loan write-offs #he guidelines require an annual re!iew of at least /8A of the &ank)s credit portfolio taking into considerationG the terms of the loan, the business of the borrower, e!aluation of the pro=ect being financed, security, and debt ser!ice #he loans are classified into fi!e categories, pass, special mentioned, substandard, doubtful, and loss Any loan classified as substandard, doubtful
16

or loss requires a pro!ision of .8A, <8A or .88A respectfully A .A pro!ision is required for the percentage of the portfolio not re!iewed %nterest should stop accruing on non-performing credits classified as substandard, doubtful or loss unless adequate security exists and full collection is expected within three months %nterest on 6o!ernment guaranteed loans should continue to accrue up to the limit of the guarantee Drite-off is recommended for loans that ha!e been classified as loss for o!er three months Too& o) Cr$dit -i k Manag$,$nt E/(o ur$ C$i&ing : *rudential Limit is linked to 7apital 4unds C say .<A for indi!idual borrower entity, 98A for a group with additional .8A for infrastructure pro=ects undertaken by the group, #hreshold limit is fixed at a le!el lower than *rudential -xposureG +ubstantial -xposure, which is the sum total of the exposures beyond threshold limit should not exceed 188A to 088A of the 7apital 4unds of the bank (i e six to eight times) -$+i$04-$n$0a&: Multi-tier 7redit Appro!ing Authority, constitution wise delegation of powers, Figher delegated powers for better-rated customersG discriminatory time schedule for re!iew"renewal, Furdle rates and &ench marks for fresh exposures and periodicity for renewal based on risk rating, etc are formulated Risk Rating Model: +et up comprehensi!e risk scoring system on a six to nine point scale 7learly define rating thresholds and re!iew the ratings periodically preferably at half yearly inter!als (ating migration is to be mapped to estimate the expected loss Risk based scientific pricing: Link loan pricing to expected loss Figh-risk category borrowers are to be priced high &uild historical data on default losses Allocate capital to absorb the unexpected loss Adopt the (A('7 framework Portfolio Management #he need for credit portfolio management emanates from the necessity to optimi$e the benefits associated with di!ersification and to reduce the potential ad!erse impact of concentration of exposures to a particular borrower, sector or industry +tipulate quantitati!e ceiling on aggregate exposure on specific rating categories, distribution of borrowers in !arious industry, business group and conduct rapid portfolio re!iews #he existing framework of tracking the non-performing loans around the balance sheet date does not signal the quality of the entire loan book #here should be a proper 5 regular on-going system for identification of credit weaknesses well in ad!ance %nitiate steps to preser!e the desired portfolio quality and integrate portfolio re!iews with credit decision-making process Loan Review Mechanism #his should be done independent of credit operations %t is also referred as 7redit Audit co!ering re!iew of sanction process, compliance status, re!iew of risk rating, pick up of warning signals and recommendation of correcti!e action with the ob=ecti!e of impro!ing credit quality %t should target all loans abo!e certain cutoff limit ensuring that at least :8A to 98A of the portfolio is sub=ected to L(M in a year
17

so as to ensure that all ma=or credit risks embedded in the balance sheet ha!e been tracked So,$ o) t#$ co,,on&! u $d ,$t#od to ,$a ur$ cr$dit ri k ar$: (atio of non performing ad!ances to total ad!ancesG (atio of loan losses to bad debt reser!esG (atio of loan losses to capital and reser!esG (atio of loan loss pro!isions to impaired creditG (atio of bad debt pro!ision to total income O($rationa& -i k ,anag$,$nt: P'perational (isk is defined as the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and system or from external e!ents Q operational risk is defined as any risk, which is not categori$ed as market or credit risk, or the risk of loss arising from !arious types of human or technical error %t is also synonymous with settlement or payments risk and business interruption, administrati!e and legal risks 'perational risk has some form of link between credit and market risks An operational problem with a business transaction could trigger a credit or market risk ?nder the &asel %% Accord, operational risk is defined as Pthe risk of loss resulting from inadequate processes, people and systems or from external e!ents Q #he management of operational risk requires systems capable of identifying, recording and quantifying operational failures that may cause financial loss #he systems are essentially tracking processes that monitor the beha!ior and performance of existing systems and processes #he essential elements include .) the ability to track and monitor performances of specified operational processes and systems, ;) maintenance of databases of operational loss experience history, and :) capacity to pro!ide exception reporting or initiate actions to enable inter!ention to reduce operational risks &ank for %nternational +ettlement (&%+) has proposed that, as of ;881, banks should be made to carry a 7apital cushion against losses from this risk Managing operational risk is becoming an important feature of sound risk management practices in modern financial markets in the wake of phenomenal increase in the !olume of transactions, high degree of structural changes and complex support systems #he most important type of operational risk in!ol!es breakdowns in internal controls and corporate go!ernance +uch breakdowns can lead to financial loss through error, fraud, or failure to perform in a timely manner or cause the interest of the bank to be compromised #he ob=ecti!es of 'perational (isk Management is to reduce the expected operational losses that focuses on systematic remo!al of operational risk sources and uses a set of key risk indicators to measure and control risk on continuous basis #he ultimate ob=ecti!e of operational risk management is to enhance the shareholder)s !alue by being ready for risk
18

based capital allocation #here is no uniformity of approach in measurement of 'perational (isk in the banking system at present M$t#od o) o($rationa& ri k ,anag$,$nt, &asel %% and !arious +uper!isory bodies of the countries ha!e prescribed !arious soundness standards for 'perational (isk Management for &anks and similar 4inancial %nstitutions #o complement these standards, &asel %% has gi!en guidance to : broad methods of 7apital calculation for 'perational (isk Ba ic indicator a((roac#, - based on annual re!enue of the 4inancial %nstitution Standardi'$d a((roac#: - based on annual re!enue of each of the broad business lines of the 4inancial %nstitution Ad!anced measurement approach, - based on the internally de!eloped risk measurement framework of the bank adhering to the standards prescribed (methods include %MA, L>A, +cenario-based, +corecard etc ) #he 'perational (isk Management framework should include identification, measurement, and monitoring, reporting, control and mitigation frameworks for 'perational (isk

-BI Guid$&in$ on ALM: As per (&% guidelines, commercial banks are to distribute the outflows"inflows in different residual maturity period known as #ime buckets #he Assets and Liabilities were earlier di!ided into 0 maturity buckets (.-.9 daysG .<-;0 daysG ;2-28 daysG 2.-.08 daysG .0.-:1< days, .-: years and :-< years and abo!e < years), based on the remaining period to their maturity residual maturity All the liability figures are outflows while the asset figures are inflows %n +eptember, ;88/, ha!ing regard to the international practices, the le!el of sophistication of banks in %ndia, the need for a sharper assessment of the efficacy of liquidity management and with a !iew to pro!iding a stimulus for de!elopment of the term-money market, (&% re!ised these guidelines and it was pro!ided thatG (a) #he banks may adopt a more granular approach to measurement of liquidity risk by splitting the first time bucket (.-.9 days at present) in the +tatement of +tructural Liquidity into three time buckets, next day, ;-/ days and 0-.9 days #hus, now we ha!e .8 time buckets

19

After such an exercise, each bucket of assets is matched with the corresponding bucket of the liability Dhen 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 mo!ement, such situation may turn out to be risky for the bank &anks are required to monitor such mismatches and take appropriate steps so that bank is not exposed to risks due to the interest rate mo!ements during that period (b) #he net cumulati!e negati!e mismatches during the 3ext day, ;-/ days, 0-.9 days and .<-;0 days buckets should not exceed < A, .8A, .< A and ;8 A of the cumulati!e cash outflows in the respecti!e time buckets in order to recogni$e the cumulati!e impact on liquidity #he &oard)s of the &anks ha!e been entrusted with the o!erall 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

E,$rging i u$ in t#$ Indian cont$/t o) ALM Dith the onset of liberali$ation, %ndian banks are now more exposed to uncertainty and to global competition #his makes it imperati!e to ha!e proper asset-liability management system in place #he following points bring out the reasons as to why asset-liability management is necessary in the %ndian context . %n the context of a bank, asset-liability management refers to the process of managing the net interest margin within a gi!en le!el of risk 3et %nterest MarginH3et interest income"A!erage earning assets 3et interest margin can be !iewed as the spread on earning assets -fficient management of net interest margin becomes essential as the basic ob=ecti!e of banks is to maximi$e income while reducing their exposure to risk ; +e!eral banks ha!e inadequate and inefficient management system that ha!e to be altered so as to ensure that the banks are sufficiently liquid

20

: An increasing proportion of in!estments by banks is being recorded on a market-tomarket basis and as such large portion of the in!estment portfolio s exposed to market risks 7ountering the ad!erse impact of these changes is possible only through efficient asset-liability management techniques 9 As the focus on the net interest margin has increased o!er the years, there is an increasing possibility that the risk arising out of exposure to interest rate !olatility will be built into the capital adequacy norms specified by the regulatory authorities #his, in turn, will require efficient asset-liability management practices In)or,ation t$c#no&og! and a $t%&iabi&it! ,anag$,$nt in t#$ Indian cont$/t Many of the new pri!ate sector banks and some of the non-banking financial companies ha!e gone in for complete computeri$ation of their branch network and ha!e also integrated their treasury, forex, and lending segments #he information technology initiati!es of these institutions pro!ide significant ad!antage to them in asset-liability management since it facilitates faster flow of information, which is accurate and reliable %t also helps in terms of quicker decision-making from the central office since branches are networked and accounts are considered as belonging to the bank rather than a branch %n other words, the boundaries of asset-liability management architecture itself is changing because of substantial changes brought about by information technology, and to that extent the operations managers are pro!ided with multiple possibilities which were not earlier a!ailable in the context of large numbers of branch networks and associated problems of information collection, storage, and retrie!al %n the %ndian context, asset-liability management refers to the management of deposits, credit, in!estments, borrowing, forex reser!es and capital, keeping in mind the capital adequacy norms laid down by the regulatory authorities %nformation technology can facilitate decisions on the following issues, . -stimating the main sources of funds like core deposits, certificates of deposits, and call borrowings . (educing the gap between rate sensiti!e assets and rate sensiti!e liabilities, gi!es a certain le!el of risk . (educing the maturity mismatches so as to a!oid liquidity problems . Managing funds with respect to crucial factors like si$e and duration LITE-ATU-E -E5IE6 #here is a considerable literature addressing asset-liability management in banks 'ne of the key moti!ators of asset-liability management worldwide was the &asel 7ommittee #he &asel 7ommittee on &anking +uper!ision (;88.) formulated broad super!isory standards and guidelines and recommended statements of best practice in banking super!ision #he purpose of the committee was to encourage global con!ergence toward common approaches and standards %n particular, the &asel %% norms (;889) were
21

proposed as an international standard for the amount of capital that banks need to set aside to guard against the types financial and operational risks they face &asel %% proposed setting up rigorous risk and capital management requirements designed to ensure that a bank holds capital reser!es appropriate to the risk the bank exposes itself to through its lending and in!estment practices 6enerally speaking, these rules mean that the greater risk to which the bank is exposed, the greater the amount of capital the bank needs to hold to safeguard its sol!ency and o!erall economic stability #his would ultimately help protect the international financial system from the types of problems that might arise should a ma=or bank or a series of banks collapse 6ardner and Mills (.22.) discussed the principles of asset-liability management as a part of banks) strategic planning and as a response to the changing en!ironment in prudential super!ision, e-commerce and new taxation treaties #heir text pro!ided the foundation of subsequent discussion on asset-liability management 6iokas and Bassiloglou (.22.) de!eloped a goal-programming model for bank asset and liability management #hey supported the idea that apart from attempting to maximi$e (e!enues, management tries to minimi$e risks in!ol!ed in the allocation of the bank)s capital, as well as to fulfill other goals of the bank, such as retaining its market share, increasing the si$e of its deposits and loans Faslem et al (.222) used canonical analysis and the interpreti!e framework of asset"liability management in order to identify and interpret the foreign and domestic balance sheet strategies of large ? + banks in the context of the Pcrisis in lending to L>7s Q #heir study found that the least profitable !ery large banks ha!e the largest proportions of foreign loans, yet they emphasi$e domestic balance sheet (asset"liability) matching strategies 7on!ersely, the most profitable !ery large banks ha!e the smallest proportions of foreign loans, but, nonetheless, they emphasi$e foreign balance sheet matching strategies Baidyanathan (.222) found that se!eral banks had inadequate and inefficient Management systems and also he argued that %ndian banks were more exposed to %nternational markets, especially with respect to 4'(-R transactions, so that Asset Liability Management was essential, as it would enable the bank to maintain its exposure to foreign currency fluctuations gi!en the le!el of risk it can handle Fe also found that an increasing proportion of in!estments by banks were being recorded on a marked-to market basis, thus being exposed to market risks Fe also suggested that, as bank profitability focus has increased o!er the years, there is an increasing possibility that the risk arising out of exposure to interest rate !olatility would be built into the capital adequacy norms specified by the regulatory authorities, thus in turn requiring efficient asset-liability management practices Baidya and +hahi (;88.) studied asset-liability management in %ndian banks #hey suggested in particular that interest rate risk and liquidity risk are two key inputs in business planning process of banks

22

(an=an and 3allari (;889) used canonical analysis to examine asset-liability management in %ndian banks in the period .22;-;889 #hey found that +&% and associates had the best asset-liability management in the period .22;-;889 #hey also found that, other than foreign banks, all other banks could be said to be liability managedG i e they all borrowed from the money market to meet their maturing obligations *ri!ate &anks were found to be aggressi!e in profit generation, while nationali$ed banks were found to be excessi!ely concerned about liquidity #here ha!e been se!eral applications of mathematical models in the field of bank management #he deterministic linear programming model of 7hambers and 7harnes (.21.) was the first of its kind in ALM 7ohen and Fammer (.21/), (obertson (.2/;) ha!e reali$ed successful applications of 7hambers and 7harnes) model -!en though these models ha!e differed in their treatment of disaggregation, uncertainty and dynamic considerations, they all ha!e in common the fact that they are specified to optimi$e a single ob=ecti!e profit function sub=ect to the rele!ant linear constraints Apart from the deterministic models, se!eral stochastic models ha!e been proposed since the .2/8s #hese models, including the use of chance-constrained programming (7harnes and #hore, .211G 7harnes and Littlechild, .210G *ogue and &ussard, .2/;), dynamic programming (+amuelson, .212G Merton, .212,.228G -ppen and 4ama, .2/.), sequential decision theory (Dolf, .212G &radley and 7rane, .2/;) and stochastic linear programming under uncertainty (7ohen and #hore, .2/8G &ooth, .2/;G 7rane, .2/.G Sallberg et al .20;), presented computational difficulties An alternati!e approach in considering stochastic models is the stochastic linear programming with simple recourse Susy and Tiemba (.201) employed a multi-period stochastic linear program with simple recourse to model the management of assets and liabilities in banking while maintaining computational feasibility #heir results indicate that the proposed ALM model is theoretically and operationally superior to a corresponding deterministic linear programming model and that the computational effort required for its implementation is comparable to that of the deterministic model Another application of the multistage stochastic programming is the (ussell-Iasuda Sasai model (7arino et al , .229), which aims at maximi$ing the long term wealth of the firm while producing high income returns Mihir >ash, (a!i *athak (;880) studied asset-liability management in %ndian banks using a linear programming model de!eloped according to the asset-liability guidelines pro!ided by the (eser!e &ank of %ndia #he study co!ers all scheduled commercial banks except regional rural banks (((&s), for the year ;88/-80 #he banks are grouped on the basis of ownership structure, public sector banks (including +&% 5 associates), pri!ate sector banks, and foreign banks #he general recommendations of the study are that banks must carefully maintain and monitor their asset-liability positions, balancing profitability, liquidity, and interest rate risk &anks which were found to satisfy all the liquidity constraints can focus on profit maximi$ationG on the other hand, banks which were found not to satisfy all the liquidity constraints should identify which particular constraints they fail, and should subsequently pursue strategies to satisfy these constraints Also, banks such as F+&7 &ank and +tandard 7hartered &ank, which were found to satisfy all liquidity constraints, but at the cost of
23

profitability, should pursue the strategy of profit maximi$ation, ensuring that they satisfy all the guidelines of (&% 4inally, banks which are exposed to interest rate risk should focus on impro!ing the duration of rate sensiti!e assets"liabilities, as far as possible +ayonton (oy (;8.8) concluded that today ALM departments are addressing (non-trading) foreign exchange risks as well as other risks Also, ALM has extended to non-financial firms 7orporations ha!e adopted techniques of ALM to address interest-rate exposures, liquidity risk and foreign exchange risk #hey are using related techniques to address commodities risks 4or example, airlinesE hedging of fuel prices or manufacturersE hedging of steel prices are often presented as ALM #hus it can be safely said that Asset Liability Management will continue to grow in future and an efficient ALM technique will go a long way in managing !olume, mix, maturity, rate sensiti!ity, quality and liquidity of the assets and liabilities so as to earn a sufficient and acceptable return on the portfolio

N$$d )or t#$ Stud!:

%ndian banks need to be !igilant in the years to come for market opportunities particularly with the competition en!isaged in the banking sector %n ;888 the beyond, the key element is that banks should stri!e to achie!e significant increase in their assets for creating a !ibrant and competiti!e financial system %n the context of global competition, it is an important task for the %ndian banks to adopt effecti!e ALM techniques to manage the !olume, mix, maturity, rate sensiti!ity, quality and liquidity of assets and liability as a whole so as to attain a predetermined acceptable risk"reward ration 6lobali$ation has mandated the %ndian &anks to be efficient in Asset and Liability Management along with the associated risk management #here is need to insulate the ALM from the risks associated with the global financial scenario in order to sur!i!e and grow in the intense competiti!e conditions An impro!ement in the ALM will result in higher profitability and resilience in the %ndian &anks #he earlier research studies indicate the critical nature of ALM *rocess in order to bring in stability in the %ndian 4inancial +ector in general and %ndian &anking +ector in particular Seeping this in !iew, the present research study is proposed to be undertaken 4or the study, Asset and Liability Management %ndian &anks in general and in &anks of the +tate &ank of %ndia (+&%), Andhra &ank, %ng Bysya &ank, and %ndustrial 7redit %n!estment 7orporation of %ndia (%7%7%) bank in particular are chosen representing two nationali$ed banks (+&%, Andhra &ank) and two *ri!ate +ector &anks (%ng Bysya &ank, %7%7%) proposed for the study +tate &ank of %ndia (+&%) is the nationEs largest and oldest bank and Andhra &ank was nationali$ed in the year .208 and ranked as best midsi$ed bank in sur!ey of %ndia)s best bank for the year ;8.8 %ng Bysya &ank oldest pri!ate sector bank in %ndia and %7%7% bank is %ndiaEs second bank (after +tate &ank of %ndia) and its largest pri!ate bank

24

Ob*$cti+$ o) t#$ tud!: *rimary 'b=ecti!e, the study aims at analy$ing and e!aluating ALM techniques and strategies followed by select banks in %ndia +pecific 'b=ecti!es,. ; : 9 < 1 / 0 #o gi!e an o!er!iew %ndian &anking %ndustry #o examine the public policy with specific reference to ALM process in %ndian &anks #o study the ALM process in the select banks #o study the reasons for Asset and Liability mismatches #o e!aluate the Liquidity"(isk management in select banks #o study the pre!ailing interest rates which affect the earning stream of banks by e!aluating %nterest (ate (isk Management #o e!aluate the Management of Market (isk #o determine the credit risk faced by the banks in order to identify the real reason behind the high le!el of 3*As and to assess the credit risk management of the banks #o offer suitable suggestions to e!ol!e a comprehensi!e ALM strategy for select banks

-$ $arc# M$t#odo&og!: Seeping the ob=ecti!es of the study in mind, an exhausti!e study of Assets and Liabilities management in commercial banks (some selected banks) has been undertaken #he data required for the purpose of the study collected from both primary and secondary sources *rimary data will be collected from the select branches of the identified banks and through detailed sur!ey of the officials of these banks 4or this purpose #he +&%, Andhra &ank and %ng Bysya &ank, %7%7% bank are taken #he secondary data will be collected from the official records, financial statements of the selected banks branches and (&% reports and bulletins 4urther rele!ant data may also be collected from @ournals, &ooks, Debsites, where e!er necessary Int$r(r$tation and Ana&! i o) Data: As the main purpose of the study is the management of assets and liabilities in 7ommercial &anks, the study implies understanding of !arious aspects related to ALM and problems aroused by asset and liabilities mismatches which is possible only with
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proper liquidity, interest rate, market risk management and funding, capital and profit planning and adopting suitable techniques and strategies #he data collected mayG be edited, classified and tabulated by using multi !ariant tables will be used where!er necessary to lend the data more precision and systemati$ation #he statistical tools like A!erages, *ercentages, and A3'BA will be used to analy$e data Sco($ o) t#$ tud!:% #he scope of the study is confirmed to the selected branches of the select banks Sc#$,$ o) C#a($ri ation: C#a(t$r I: Introduction -- this chapter is intended to deal with the conceptual analysis of Asset and Liability management in banks, ALM process, the international norms &A+-L % and &A+-L %%, the (&% policy, &ench marking, (isk exposure, Literature sur!ey, need for the study, methodology etc C#a(t$r II: Banking Indu tr! in India 7 Tr$nd and "$r)or,anc$ 7 #his chapter is to deal with the brief introduction of %ndian banking industry, the phases of financial sector reforms, recommendations of the 3arasimham committee, current scenario of the banking industry in %ndia C#a(t$r II: Li1uidit! and Fund Manag$,$nt Uthis chapter includes meaning, dimensions, causes, symptoms, factors of liquidity risk, liquidity measurement approaches, (&% guidelines on liquidity risk and contingency plan for liquidity management and fund management C#a(t$r III: Int$r$ t -at$ -i k Manag$,$nt C this chapter includes measuring interest rate risk, 6A* analysis, preparation of 6A* report, 6A* analysis prudential norms, altering 6A*, duration 6A* analysis and simulation C#a(t$r I5: Manag$,$nt o) Mark$t -i k C this chapter explains trade and foreign exchange risk, #ransaction exposure, #echniques of foreign exchange risk, 4utures and 4orward contracts, >eri!ati!es, 'ptions and +waps C#a(t$r 5: O($rationa& -i k ,anag$,$nt 7 this chapter explains meaning of operational risk, ob=ecti!es and method operational risk management C#a(t$r 5I: Conc&u ion and Sugg$ tion -- #his chapter is to conclude the topic by gi!ing suggestions #he ALM would help the banks to boost up their profits, smooth recycling of funds in the nation #his would help the nation to de!elop more banking branches and de!eloping the economy by pro!iding the better financial ser!ices to the nation (eferences, . ; Alexander Adam, P#he Fand &ook of Asset and Liability Management- from models to optimal return strategiesQ, the Diley 5 +ons financial series Moorad 7howdary, P&ank Asset and Liability Management, strategy, trading and analysisQ, the Diley 5 +ons financial series
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>r & 7harumathi, PAsset Liability Management in %ndian &anking %ndustry with special reference to %nterest (ate (isk Management in %7%7% &ankQ, *roceedings of the Dorld 7ongress on -ngineering ;880 Bol %% , D7- ;880, @uly ; - 9, ;880, London, ? S 9 PAsset Liability Management in &anksQ, a presentation by Siran +harma member of 4aculty 7A&, (&%, *?3< ( Baidyanadhan, PAsset and Liability Management, %ssues and #rends in %ndian contextQ, A+7% @ournal of Management ;2(.) :2-90, 7opyrightV .222 Administrati!e +taff 7ollege of %ndia 1 PAsset Liability Management Module AQ, 7 + &alakrishnana, 4aculty member, +*&# 7ollege / (a!i *athak, P7anonical 7orrelation Analysis of Asset and Liability Management of %ndian &anksQ, -lectronic copy a!ailable at, http,""ssrn com"abstractH.9.;/:2 0 Fimanshu hawasthi, PAsset-Liability Management-An %ndian *erspecti!eQ, :8 +eptember ;880 2 PAsset Libility Management, An '!er!iewQ, An 'racle 4inancial +er!ices .8 P(isk Management in &anksQ, ( A (agha!an, 7harted accountant, 4ebruary ;88: .. >r & 7harumathi, PAsset Liability Management in %ndian &anking %ndustry with special reference to %nterest (ate (isk Management in %7%7% &ankQ, *roceedings of the Dorld 7ongress on -ngineering ;880 Bol %%, @uly ; - 9, ;880, London, ? S .; P(isk Management and Asset and Liability Management in &anksQ, 4ocus *aper, #echnical Assistance 7onsultant)s (eport #A 19<9 ((-6), +upporting (egional 7apacities for 4inancial Asset and Liability and (isk Management .: +ri!idhya Muralikrishnan, PAsset Liability Management - the %ndian *erspecti!eQ, Asian de!elopment bank, #ata consultancy ser!ices (#7+) -;2 May ;88/, A!ailable at, www gtnews com

.9 Bibha &atra, Sarthik +rini!asan, *uneet Maheshwari, P%ndian &anking +ector, 7hallenges unlikely to derail the progress madeQ, %7(A, @une, ;8.. .< .< 3arendra @adha!, P-merging %ssues in &anking and 4inancial +ector in %ndiaQ, >&'> 3o &* ;<1 " ;. 89 820" ;88/-80, +eptember <, ;88/ .1 Asset Liability Management +ystem %n &ank C (&% 6uidelines, 3o!ember ..th, ;8.8 ./ 4rom 7ompliance to %nternal Assessment - %s risk management by %ndian banks dri!en from withinV %ndian &ank Association .0 3icolae & 6arleanu, Lasse F *edersen, PLiquidity and (isk ManagementQ, Dorking *aper .;00/ A!ailable at, http,""www nber org"papers"w.;00/ .2 .2 7 + &ala Srishnan,Q Asset Liability ManagementQ, 4aculty member of +*&# 7ollege

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;8 ;8 7howdarip,Q Asset Liability Management in &ankingQ, A!ailable at, www authorstream com"presentaion"chowdarip-./0/.8 ;. ;. *eter (ose, +yl!ia Fudgins, P&ank Management 5 4inancial +er!icesQ, 7hapter /, Asset and Liability Management, >etermining and measuring %nterest (ates and 7ontrolling %nterest +ensiti!e and >uration 6A*s ;; ;; Bikram +ingh +ankhala,Q Asset Liability ManagementQ, on 3o!ember 2 th ;8.8, A!ailable at, www slideshare net"!ikramsankhala"asset-liabilitymanagement-</..991 ;: PAsset Liability system management in banks guidelinesQ, A!ailable at, http,""rbidocs rbi org in"rdocs"*ress(elease"*>4s":;89 pdf

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