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Risk Management In Banking

CIA II: Management of Banking and Financial Institutions

Submitted By: Aditi Nag 1021137; Vinutha V Jois 1021154; Apoorv Jhudeley 1021207

Introduction Asset Liability Management (ALM) can be defined as a mechanism to address the risk faced by a bank due to a mismatch between assets and liabilities either due to liquidity or changes in interest rates. Apart from liquidity, a bank may also have a mismatch due to changes in interest rates as banks typically tend to borrow short term (fixed or floating) and lend long term (fixed or floating). A comprehensive ALM policy framework focuses on bank profitability and long term viability by targeting the net interest margin (NIM) ratio and Net Economic Value (NEV), subject to balance sheet constraints. Significant among these constraints are maintaining credit quality, meeting liquidity needs and obtaining sufficient capital. ALM simply combines portfolio management techniques (that is, asset, liability and spread management) into a coordinated process. Thus, the central theme of ALM is the coordinated and not piecemeal management of a banks entire balance sheet. ALM includes sophisticated concepts such as duration matching, variable rate pricing, and the use of static and dynamic simulation. Measuring Risk Interest rate risk (IRR) largely poses a problem to a banks net interest income and hence profitability. Changes in interest rates can significantly alter a banks net interest income (NII), depending on the extent of mismatch between the asset and liability interest rate reset times. Changes in interest rates also affect the market value of a banks equity. Methods of managing IRR first require a bank to specify goals for either the book value or the market value of NII. The immediate focus of ALM is interest-rate risk and return as measured by a banks net interest margin. NIM = (Interest income Interest expense) / Earning assets A banks NIM, in turn, is a function of the interest-rate sensitivity, volume, and mix of its earning assets and liabilities. That is, NIM = f (Rate, Volume, Mix) Sources of interest rate risk The primary forms of interest rate risk include repricing risk, yield curve risk, basis risk and optionality.

Asset - Liability Management System in banks - Guidelines

Over the last few years the Indian financial markets have witnessed wide ranging changes at fast pace. Intense competition for business involving both the assets and liabilities, together with increasing volatility in the domestic interest rates as well as foreign exchange rates, has brought pressure on the management of banks to maintain a good balance among spreads, profitability and long-term viability. These pressures call for structured and comprehensive measures and not just ad hoc action. The Management of banks has to base their business decisions on a dynamic and integrated risk management system and process, driven by corporate strategy. Banks are exposed to several major risks in the course of their business - credit risk, interest rate risk, foreign exchange risk, equity / commodity price risk, liquidity risk and operational risks. 2. This note lays down broad guidelines in respect of interest rate and liquidity risks management systems in banks which form part of the Asset-Liability Management (ALM) function. The initial focus of the ALM function would be to enforce the risk management discipline viz. managing business after assessing the risks involved. The objective of good risk management programmes should be that these programmes will evolve into a strategic tool for bank management. 3. The ALM process rests on three pillars: yALM information systems => Management Information System => Information availability, accuracy, adequacy and expediency yALM organisation => Structure and responsibilities => Level of top management involvement yALM process => Risk parameters => Risk identification => Risk measurement => Risk management => Risk policies and tolerance levels.

4. ALM information systems

Information is the key to the ALM process. 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 behavioural 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. analysing the behaviour 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 centralised 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 computerisation will also help banks in accessing data.

5. ALM organisation
5.1 a) The Board should have overall responsibility for management of risks and should decide the risk management policy of the bank and set limits for liquidity, interest rate, foreign exchange and equity price risks. b) 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. c) The ALM desk consisting of operating staff should be responsible for analysing, 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. 5.2 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. 5.3 Composition of ALCO The size (number of members) of ALCO would depend on the size of each institution, business mix and organisational complexity. To ensure commitment of the 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 computerisation. Some banks may even have sub-committees. 5.4 Committee of Directors Banks should also constitute a professional Managerial and Supervisory Committee consisting of three to four directors which will oversee the implementation of the system and review its functioning periodically. 5.5 ALM process: The scope of ALM function can be described as follows: yLiquidity risk management yManagement of market risks (including Interest Rate Risk) yFunding and capital planning yProfit planning and growth projection yTrading risk management The guidelines given in this note mainly address Liquidity and Interest Rate risks.

6. Liquidity Risk Management

6.1 Measuring and managing liquidity needs are vital activities of commercial banks. By assuring a bank's ability to meet its liabilities as they become due, liquidity management can reduce the probability of an adverse situation developing. The importance of liquidity transcends individual institutions, as liquidity shortfall in one institution can have repercussions on the entire system.

Bank management should measure not only the liquidity positions of banks on an ongoing basis but also examine how liquidity requirements are likely to evolve under crisis scenarios. Experience shows that assets commonly considered as liquid like Government securities and other money market instruments could also become illiquid when the market and players are unidirectional. Therefore liquidity has to be tracked through maturity or cash flow mismatches. For measuring and managing net funding requirements, the use of a maturity ladder and calculation of cumulative surplus or deficit of funds at selected maturity dates is adopted as a standard tool. The format of the Statement of Structural Liquidity is given in Annexure I. 6.2 The Maturity Profile as given in Appendix I could be used for measuring the future cash flows of banks in different time buckets. The time buckets given the Statutory Reserve cycle of 14 days may be distributed as under: i. 1 to 14 days ii. 15 to 28 days iii. 29 days and upto 3 months iv. Over 3 months and upto 6 months v. Over 6 months and upto 12 months vi. Over 1 year and upto 2 years vii. Over 2 years and upto 5 years viii. Over 5 years 6.3 Within each time bucket there could be mismatches depending on cash inflows and outflows. While the mismatches upto one year would be relevant since these provide early warning signals of impending liquidity problems, the main focus should be on the short-term mismatches viz., 114 days and 15-28 days. Banks, however, are expected to monitor their cumulative mismatches (running total) across all time buckets by establishing internal prudential limits with the approval of the Board / Management Committee. The mismatch during 1-14 days and 15-28 days should not in any case exceed 20% of the cash outflows in each time bucket. If a bank in view of its asset -liability profile needs higher tolerance level, it could operate with higher limit sanctioned by its Board / Management Committee giving reasons on the need for such higher limit. A copy of the note approved by Board / Management Committee may be forwarded to the Department of Banking Supervision, RBI. The discretion to allow a higher tolerance level is intended for a temporary period, till the system stabilises and the bank is able to restructure its asset -liability pattern. 6.4 The Statement of Structural Liquidity ( Annexure I ) may be prepared by placing all cash inflows and outflows in the maturity ladder according to the expected timing of cash flows. A maturing liability will be a cash outflow while a maturing asset will be a cash inflow. It would be necessary to take into account the rupee inflows and outflows on account of forex operations including the readily available forex resources ( FCNR (B) funds, etc) which can be deployed for augmenting rupee resources. While determining the likely cash inflows / outflows, banks have to make a number of assumptions according to their asset - liability profiles. For instance, Indian banks with large branch network can (on the stability of their deposit base as most deposits are renewed) afford to have larger tolerance levels in mismatches if their term deposit base is quite high. While determining the tolerance levels the banks may take into account all relevant factors based on their asset-liability base, nature of business, future strategy etc. The RBI is interested in ensuring that the tolerance levels are determined keeping all necessary factors in view and further refined with experience gained in Liquidity Management.

6.5 In order to enable the banks to monitor their short-term liquidity on a dynamic basis over a time horizon spanning from 1-90 days, banks may estimate their short-term liquidity profiles on the basis of business projections and other commitments. An indicative format ( Annexure III ) for estimating Short-term Dynamic Liquidity is enclosed.

7. Currency Risk
7.1 Floating exchange rate arrangement has brought in its wake pronounced volatility adding a new dimension to the risk profile of banks' balance sheets. The increased capital flows across free economies following deregulation have contributed to increase in the volume of transactions. Large cross border flows together with the volatility has rendered the banks' balance sheets vulnerable to exchange rate movements. 7.2 Dealing in different currencies brings opportunities as also risks. If the liabilities in one currency exceed the level of assets in the same currency, then the currency mismatch can add value or erode value depending upon the currency movements. The simplest way to avoid currency risk is to ensure that mismatches, if any, are reduced to zero or near zero. Banks undertake operations in foreign exchange like accepting deposits, making loans and advances and quoting prices for foreign exchange transactions. Irrespective of the strategies adopted, it may not be possible to eliminate currency mismatches altogether. Besides, some of the institutions may take proprietary trading positions as a conscious business strategy. 7.3 Managing Currency Risk is one more dimension of Asset- Liability Management. Mismatched currency position besides exposing the balance sheet to movements in exchange rate also exposes it to country risk and settlement risk. Ever since the RBI (Exchange Control Department) introduced the concept of end of the day near square position in 1978, banks have been setting up overnight limits and selectively undertaking active day time trading. Following the introduction of "Guidelines for Internal Control over Foreign Exchange Business" in 1981, maturity mismatches (gaps) are also subject to control. Following the recommendations of Expert Group on Foreign Exchange Markets in India (Sodhani Committee) the calculation of exchange position has been redefined and banks have been given the discretion to set up overnight limits linked to maintenance of additional Tier I capital to the extent of 5 per cent of open position limit. 7.4 Presently, the banks are also free to set gap limits with RBI's approval but are required to adopt Value at Risk (VaR) approach to measure the risk associated with forward exposures. Thus the open position limits together with the gap limits form the risk management approach to forex operations. For monitoring such risks banks should follow the instructions contained in Circular A.D (M. A. Series) No.52 dated December 27, 1997 issued by the Exchange Control Department.

8. Interest Rate Risk (IRR)

8.1 The phased deregulation of interest rates and the operational flexibility given to banks in pricing most of the assets and liabilities have exposed the banking system to Interest Rate Risk. Interest rate risk is the risk where changes in market interest rates might adversely affect a bank's financial condition. Changes in interest rates affect both the current earnings (earnings perspective) as also the net worth of the bank (economic value perspective). The risk from the earnings' perspective can be measured as changes in the Net Interest Income (Nil) or Net Interest Margin (NIM). In the context of poor MIS, slow pace of computerisation in banks and the absence of total deregulation, the traditional Gap analysis is considered as a suitable method to measure the Interest Rate Risk. It is the intention of RBI to move over to modern techniques of Interest Rate Risk measurement like Duration Gap Analysis, Simulation and Value at Risk at a later date when banks acquire sufficient expertise and sophistication in MIS. The Gap or Mismatch risk can be measured by calculating Gaps over different time intervals as at a given date. Gap analysis measures mismatches between rate sensitive liabilities and rate sensitive assets

(including off-balance sheet positions). An asset or liability is normally classified as rate sensitive if: i) Within the time interval under consideration, there is a cash flow; ii) The interest rate resets/reprices contractually during the interval; iii) RBI changes the interest rates (i.e. interest rates on Savings Bank Deposits, advances upto Rs.2 lakhs, DRI advances, Export credit, Refinance, CRR balance, etc.) in cases where interest rates are administered ; and iv) It is contractually pre-payable or withdrawable before the stated maturities. 8.2 The Gap Report should be generated by grouping rate sensitive liabilities, assets and offbalance sheet positions into time buckets according to residual maturity or next repricing period, whichever is earlier. The difficult task in Gap analysis is determining rate sensitivity. All investments, advances, deposits, borrowings, purchased funds etc. that mature/reprice within a specified timeframe are interest rate sensitive. Similarly, any principal repayment of loan is also rate sensitive if the bank expects to receive it within the time horizon. This includes final principal payment and interim instalments. Certain assets and liabilities receive/pay rates that vary with a reference rate. These assets and liabilities are repriced at pre-determined intervals and are rate sensitive at the time of repricing. While the interest rates on term deposits are fixed during their currency, the advances portfolio of the banking system is basically floating. The interest rates on advances could be repriced any number of occasions, corresponding to the changes in PLR. The Gaps may be identified in the following time buckets: i. upto 1 month ii. Over one month and upto 3 months iii. Over 3 months and upto 6 months iv. Over 6 months and upto 12 months v. Over 1 year and upto 3 years vi. Over 3 years and upto 5 years vii. Over 5 years viii. Non-sensitive The various items of rate sensitive assets and liabilities in the Balance Sheet may be classified as explained in Appendix - II and the Reporting Format for interest rate sensitive assets and liabilities is given in Annexure II. 8.3 The Gap is the difference between Rate Sensitive Assets (RSA) and Rate Sensitive Liabilities (RSL) for each time bucket. The positive Gap indicates that it has more RSAs than RSLs whereas the negative Gap indicates that it has more RSLs. The Gap reports indicate whether the institution is in a position to benefit from rising interest rates by having a positive Gap (RSA > RSL) or whether it is in a position to benefit from declining interest rates by a negative Gap (RSL > RSA). The Gap can, therefore, be used as a measure of interest rate sensitivity. 8.4 Each bank should set prudential limits on individual Gaps with the approval of the Board/Management Committee. The prudential limits should have a bearing on the total assets, earning assets or equity. The banks may work out earnings at risk, based on their views on interest rate movements and fix a prudent level with the approval of the Board/Management Committee. 8.5 RBI will also introduce capital adequacy for market risks in due course. 9. The classification of various components of assets and liabilities into different time buckets for preparation of Gap reports (Liquidity and Interest Rate Sensitivity) as indicated in Appendices I

& II is the benchmark. Banks which are better equipped to reasonably estimate the behavioural pattern, embedded options, rolls-in and rolls-out, etc of various components of assets and liabilities on the basis of past data / empirical studies could classify them in the appropriate time buckets, subject to approval from the ALCO / Board. A copy of the note approved by the ALCO / Board may be sent to the Department of Banking Supervision.

Maturity Profile - Liquidity
Heads of Accounts Classification into time buckets

A. Outflows
1. Capital, Reserves and Surplus 2. Demand Deposits (Current and Savings Bank Deposits) Over 5 years bucket. Demand Deposits may be classified into volatile and core portions. 25% of deposits are generally withdrawable on demand. This portion may be treated as volatile. While volatile portion can be placed in the first time bucket i.e., 1-14 days, the core portion may be placed in 1 - 2 years bucket. Respective maturity buckets. Respective maturity buckets.

3. Term Deposits 4. Certificates of Deposit, Borrowings and Bonds (including Sub-Ordinated Debt) 5. Other Liabilities and Provisions (i) Bills Payable (ii) Inter-office Adjustment

(i) 1-14 days bucket. (ii) As per trend analysis. Items not representing cash payables, may be placed in over 5 years bucket. (iii) a) 2-5 years bucket. b) Over 5 years bucket. (iv) Over 5 years bucket. (v) a) 2-5 years bucket. b) Over 5 years bucket. (vi) Respective buckets depending on the purpose. (vii) Respective maturity buckets. Items not representing cash payables (i.e. income received in advances etc.) may be placed in over 5 years bucket.

(iii) Provisions for NPAs a) Sub-standard b) Doubtful and Loss (iv) Provisions for depreciation in investments (v) Provisions for NPAs in investments a) Sub-standard b) Doubtful and Loss (vi) Provisions for other purposes (vii) Other Liabilities

B. Inflows
1. Cash 2. Balances with RBI 1-14 days bucket While the excess balance over the required CRR/SLR may be shown under 1-14 days bucket, the Statutory Balances may be distributed amongst various time buckets corresponding to the maturity profile of DTL with a timelag of 14 days.

3. Balances with other Banks (i) Current Account

(i) Non-withdrawable portion on account of stipulations of minimum balances may be shown under 1-2 years bucket and the remaining balances may be shown under 1-14 days bucket. (ii) Respective maturity buckets.

(ii) Money at Call and Short Notice, Term Deposits and other placements 4. Investments (i) Approved securities

(i) Respective maturity buckets excluding the amount required to be reinvested to maintain SLR corresponding to the DTL profile in various time buckets.

(ii) Corporate debentures and bonds, PSU bonds, CDs and CPs, Redeemable preference Shares, Units of Mutual Funds (close ended), etc. (iii) Shares / Units of Mutual Funds (open ended) (iv) Investments in subsidiaries/Joint Ventures 5. Advances (Performing) (i) Bills Purchased and Discounted (including bills under DUPN) (ii) Cash Credit/Overdraft (including TOD) and Demand Loan component of Working Capital.

(ii) Respective maturity buckets. Investments classified as NPAs should be shown under 2-5 years bucket (substandard) or over 5 years bucket (doubtful and loss).

(iii) Over 5 years bucket.

(iv) Over 5 years bucket.

(i) Respective maturity buckets.

(ii) Banks should undertake a study of behavioural and seasonal pattern of availments based on outstandings and the core and volatile portion should be identified. While the volatile portion could be shown in the respective maturity buckets, the core portion may be shown under 1-2 years bucket. (iii) Interim cash flows may be shown under respective maturity buckets. (i) 2-5 years bucket. (ii) Over 5 years bucket. Over 5 years bucket (i) As per trend analysis. Intangible items or items not representing cash receivables may be shown in over 5 years bucket. (ii) Respective maturity buckets. Intangible assets and assets not representing cash receivables may be shown in over 5 years bucket.

(iii) Term Loans 6. NPAs (i) Sub-standard (ii) Doubtful and Loss 7. Fixed Assets 8. Other Assets (i) Inter-office Adjustment

(ii) Others

C. Contingent Liabilities / Lines of Credit committed / available and other Inflows / Outflows
1. (i) Lines of Credit committed to Institutions (outflow) (ii) Unavailed portion of Cash Credit / Overdraft / Demand loan component of Working Capital limits (outflow) (i) 1-14 days bucket.

(ii) Banks should undertake a study of the behavioural and seasonal pattern of potential availments from the accounts and the amounts so arrived at may be shown under relevant maturity buckets upto 12 months.

2. Letters of Credit / Guarantees (outflow) Historical trend analysis ought to be conducted on the devolvements and the amounts so arrived at in respect of outstanding Letters of Credit / Guarantees (net of margins) should be distributed amongst various time buckets. 3. Repos / Bills Rediscounted (DUPN) / Respective maturity buckets. Swaps INR / USD, maturing forex forward contracts etc. (outflow / inflow) 4. Interest payable / receivable (outflow / inflow) Respective maturity buckets.

Note : (i) Liability on account of any other contingency may be shown under respective maturity buckets. (ii) All overdue liabilities may be placed in the 1-14 days bucket. (iii) Interest and instalments from advances and investments, which are overdue for less than one month may be placed in the 3-6 months, bucket. Further, interest and instalments due (before classification as NPAs) may be placed in the 6-12 months bucket without the grace period of one month if the earlier receivables remain uncollected.

D. Financing of Gap:
In case the negative gap exceeds the prudential limit of 20% of outflows, the bank may show by way of a foot note as to how it proposes to finance the gap to bring the mismatch within the prescribed limits. The gap can be financed from market borrowings (call / term), Bills Rediscounting, Refinance from RBI / others, Repos and deployment of foreign currency resources after conversion into rupees ( unswapped foreign currency funds ) etc.

Effects of interest rate risk Changes in interest rates can have adverse effects both on a banks earnings and its economic value. The earnings perspective: From the earnings perspective, the focus of analyses is the impact of changes in interest rates on accrual or reported earnings. Variation in earnings (NII) is an important focal point for IRR analysis because reduced interest earnings will threaten the financial performance of an institution. Economic value perspective: Variation in market interest rates can also affect the economic value of a banks assets, liabilities, and Off Balance Sheet (OBS) positions. Since the economic value perspective considers the potential impact of interest rate changes on the present value of all future cash flows, it provides a more comprehensive view of the potential long-term effects of changes in interest rates than is offered by the earnings perspective. Interest rate sensitivity and GAP management This model measures the direction and extent of asset-liability mismatch through a funding or maturity GAP (or, simply, GAP). 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. For each time bucket the GAP equals the difference between the interest rate sensitive assets (RSAs) and the interest rate sensitive liabilities (RSLs). In symbols: GAP = RSAs RSLs When interest rates change, the banks NII changes based on the following interrelationships: NII = (RSAs - RSLs) x r NII = GAP x r A zero GAP will be the best choice either if the bank is unable to speculate interest rates accurately or if its capacity to absorb risk is close to zero. With a zero GAP, the bank is fully protected against both increases and decreases in interest rates as its NII will not change in both cases. As a tool for managing IRR, GAP management suffers from three limitations: Financial institutions in the normal course are incapable of out-predicting the markets, hence maintain the zero GAP. It assumes that banks can flexibly adjust assets and liabilities to attain the desired GAP. It focuses only on the current interest sensitivity of the assets and liabilities, and ignores the effect of interest rate movements on the value of bank assets and liabilities. Cumulative GAP model In this model, the sum of the periodic GAPs is equal to the cumulative GAP measured by the maturity GAP model. While the periodic GAP model corrects many of the deficiencies of the GAP model, it does not explicitly account for the influence of multiple market rates on the interest income. Duration GAP model (DAGAP) Duration is defined as the average life of a financial instrument. It also provides an approximate measure of market value interest elasticity. Duration analysis begins by

computing the individual duration of each asset and liability and weighting the individual durations by the percentage of the asset or liability in the balance sheet to obtain the combined asset and liability duration. DURgap = DURassets Kliabilities DURliabilities Where, Kliabilities = Percentage of assets funded by liabilities DGAP directly indicates the effect of interest rate changes on the net worth of the institution. The funding GAP technique matches cash flows by structuring the short-term maturity buckets. On the other hand, the DGAP hedges against IRR by structuring the portfolios of assets and liabilities to change equally in value whenever the interest rate changes. If DGAP is close to zero, the market value of the banks equity will not change and, accordingly, become immunised to any changes in interest rates. DGAP analysis improves upon the maturity and cumulative GAP models by taking into account the timing and market value of cash flows rather than the horizon maturity. It gives a single index measure of interest rate risk exposure. The application of duration analysis requires extensive data on the specific characteristics and current market pricing schedules of financial instruments. However, for institutions which have a high proportion of assets and liabilities with embedded options, sensitivity analysis conducted using duration as the sole measure of price elasticity is likely to lead to erroneous results due to the existence of convexity in such instruments. Apart from this, duration analysis makes an assumption of parallel shifts in the yield curve, which is not always true. To take care of this, a high degree of analytical approach to yield curve dynamics is required. However, immunisation through duration eliminates the possibility of unexpected gains or losses when there is a parallel shift in the yield curve. In other words, it is a hedging or riskminimisation strategy; not a profit-maximisation strategy. Simulation analysis Simulations serve to construct the risk-return profile of the banking portfolio. Scenario analysis addresses the issue of uncertainty associated with the future direction of interest rates by allowing the analysis of isolated attributes with the use of what if simulations. However, it is debatable if simulation analysis, with its attendant controls and ratification methods, can effectively capture the dynamics of yield curve evolution and interest rate sensitivity of key financial variables. Managing Interest Rate Risk Depending upon the risk propensity of an institution, risk can be controlled using a variety of techniques that can be classified into direct and synthetic methods. The direct method of restructuring the balance sheet relies on changing the contractual characteristics of assets and liabilities to achieve a particular duration or maturity GAP. On the other hand, the synthetic method relies on the use of instruments such as interest rate swaps, futures, options and customised agreements to alter the balance sheet risk exposure. Since direct restructuring may not always be possible, the availability of synthetic methods adds a certain degree of flexibility to the asset-liability GAP management process. In addition, the process of securitisation and financial engineering can also be used to create assets with wide investor appeal in order to adjust asset-liability GAPs. Using interest rate swaps to hedge interest rate risk Interest rate swaps (IRS) represent a contractual agreement between a financial institution and a counterparty to exchange cash flows at periodic intervals, based on a notional amount.

The purpose of an interest rate swap is to hedge interest rate risk. By arranging for another party to assume its interest payments, a bank can put in place such a hedge. Financial institutions can use such swaps to synthetically convert floating rate liabilities to fixed rate liabilities. The arbitrage potential associated with different comparative financing advantages (spreads) enables both parties to benefit through lower borrowing costs. In case of a falling interest rate scenario, prepayment will increase with an attendant shortening of the assets average life. The financial institution may have to continue exchanging swap cash flows for a period longer than the average life of the asset. In order to protect such situations, options on swaps or swaptions may be used. Call options on swaps allow the financial institution to call the swap, while put options on swaps allow the institution to activate or put the swap after a specific period. Using financial futures to hedge interest rate risk A futures contract is an agreement between a buyer and seller to exchange a fixed quantity of a financial asset at an agreed price on a specified date. Interest rate futures (IRF) can be used to control the risk associated with the asset/liability GAP either at the macro-level or at the micro-level. A macro-hedge is used to protect the entire balance sheet, whereas a microhedge is applied to individual assets or transactions. A buyer, holding a long position, would purchase a futures contract when interest rates are expected to fall. The seller of a futures contract, on the other hand, would take a short position in anticipation of rising rates. The protection provided by financial futures is symmetric in that losses (or gains) in the value of the cash position are offset by gains (or losses) in the value of the futures position. Forward contracts are also available to hedge against exchange rate risk. Futures contracts are not without their own risks. Among the most important is basis risk, especially prevalent in cross hedging. Financial institutions must also pay close attention to the hedging ratio, and managements must be careful to follow regulatory and accounting rules governing the use of futures contracts. Using options to hedge interest rate risk Options can be used to create a myriad risk-return profiles using two essential ingredients: calls and puts. Call option strategies are profitable in bullish interest rate scenarios. With respect to the ALM process, options can be used for reducing risk and enhancing yield. Put options can be used to provide insurance against price declines, with limited risk if the opposite occurs. Similarly, call options can be used to enhance profits if the market rallies, with the maximum loss restricted to the upfront premium. Customised interest rate agreements Customised interest rate agreements is the general term used to classify instruments such as interest rate caps and floors. In return for the protection against rising liability costs, the cap buyer pays a premium to the cap seller. The pay-off profile of the cap buyer is asymmetric in nature, in that if interest rates do not rise, the maximum loss is restricted to the cap premium. Since the cap buyer gains when interest rates rise, the purchase of a cap is comparable to buying a strip of put options. Similarly, in return for the protection against falling asset returns, the floor buyer pays a premium to the seller of the floor. The pay-off profile of the floor buyer is also asymmetric in nature since the maximum loss is restricted to the floor premium. As interest rates fall, the pay-off to the buyer of the floor increases in proportion to the fall in rates. In this respect, the purchase of a floor is comparable to the purchase of a strip of call options.

By buying an interest rate cap and selling an interest rate floor to offset the cap premium, financial institutions can also limit the cost of liabilities to a band of interest rate constraints. This strategy, known as an interest rate collar, has the effect of capping liability costs in rising rate scenarios. The role of securitisation in ALM By using securitisation, financial institutions can create securities suitable for resale in capital markets from assets which otherwise would have been held to maturity. In addition to providing an alternative route for asset/liability restructuring, securitisation may also be viewed as a form of direct financing in which savers are directly lending to borrowers. Securitisation also provides the additional advantage of cleansing the balance sheet of complex and highly illiquid assets as long as the transformations required to enhance marketability are available on a cost-effective basis. Securitisation transfers risks such as interest rate risk, credit risk (unless the loans are securitised with full or partial recourse to the originator) and pre-payment risk to the ultimate investors of the securitised assets. Besides increasing the liquidity and diversification of the loans portfolio, securitisation allows a financial institution to recapture some part of the profits of lending and permits reduction in the cost of intermediation.

Conclusion As the landscape of the financial services industry becomes increasingly competitive, with rising costs of intermediation due to higher capital requirements and deposit insurance, financial institutions face a loss of spread income. In order to enhance the loss in profitability due to such developments, financial institutions may be forced to deliberately mismatch asset/liability maturities in order to generate higher spreads. ALM is a systematic approach that attempts to provide a degree of protection to the risk arising out of the asset/liability mismatch. ALM consists of a framework to define, measure, monitor, modify and manage liquidity and interest rate risk. It is not always possible for financial institutions to restructure the asset and liability mix directly to manage asset/liability GAPs. Hence, off-balance sheet strategies such as interest rate swaps, options, futures, caps, floors, forward rate agreements, swap-options, and so on, can be used to create synthetic hedges to manage asset/ liability GAPs.

Sources 1. 2. 3. Reserve Bank of India Asset Liability Management Guidelines 4. 5. 6.