Asset Liability Management in Banks

ASSET LIABILITY MANAGEMENT IN BANKS

Submitted in partial fulfillment of the requirements

for (Master of Management Studies)
(Year 2008-2010)

PROJECT GUIDE
Prof. Gazia Sayed

SUBMITTED BY
Name: Richa Motiramani
(MMS II) Roll No. M-08-29
Batch: (2008 - 2010)

IES Management College and Research Centre

University of Mumbai

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 Asset Liability Management in Banks

CERTIFICATE

This is to certify that project titled: Asset Liability Management in

Banks has been submitted by Ms. Richa Motiramani towards partial

fulfillment of the requirements of the Master of Management Studies

(MMS) degree course 2008 - 2010 and has been carried out by her

under the guidance of Ms. Gazia Sayed at the IES Management

College and Research Centre affiliated to the University of Mumbai.

The matter presented in this report has not been submitted for any

other purpose in this Institute.

_______________________ ___________________________

Guide : Prof. Gazia Sayed Director : Dr.Dinesh D. Harsolekar

Place : Place :

Date : Date :

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 Asset Liability Management in Banks

ACKNOWLEDGEMENT

Like every project needs direction this one is no exception. I would therefore,
like to express my sincere gratitude to Prof. Gazia Sayed for helping me in this
project. Her valuable suggestions and insights have helped achieve much
more than what was conceived of the project at its inception. I would also like
to thank my friends who were also a great support while working on the
project.

I believe the project would have been incomplete without their support.

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 Asset Liability Management in Banks

TABLE OF CONTENTS
Sr. Pg.
No. Topic No.
1. Executive Summary 6.
2. Asset Liability Management 7.
3. Components of Financial Statements 9.
3.1 Balance Sheet 9.
3.2 Profit & Loss Account 11.
4. Rate Sensitive Assets and Liabilities 13.
5. Risk Associated with Asset Liability Management 14.
6. Purpose of Asset Liability Mismatch 18.
7. Addressing the Mismatches 19.
8. Elements of Asset Liability Management 21.
9. Three Pillars of ALM 23.
10. Asset Liability Committee – ALCO 25.
10.1 Process of ALCO 27.
10.2 Organization Structure of ALCO 28.
11. ALM Approach 29.
11.1 Liquidity Risk Management 29.
11.2 Asset Management 32.
11.3 Liability Management 33.
12. Procedure for examining Asset Liability Management 35.
13. Regulatory Framework 38.
14. Issues in implementation of ALM 40.
15. Techniques of ALM 42.
15.1 Gap Analysis Model 42.
15.2 Duration Gap Analysis Model 46.
15.3 Simulation Analysis 47.
15.4 Value at Risk 49.
16. GAP & NII 50.
17. Bibliography 54.

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1. EXECUTIVE SUMMARY

Asset Liability Management is the most important aspect for the Banks to
manage Balance Sheet Risk, especially for managing of liquidity risk and
interest rate risk. Failure to identify the risks associated with business and
failure to take timely measures in giving a sense of direction threatens the
very existence of the institution.

Implementing Asset Liability Management (ALM) function in banks is not only

a regulatory requirement in India but also an imperative for strategic bank
management. With profit becoming the a key-factor, it has now become
imperative for banks to move towards integrated balance sheet management
where components of balance sheet and its different maturity mix will be
looked at profit angle of the bank.

Asset Liability Management is based on three pillars and they are ALM
Information System, ALM Organization and ALM Process. ALM brings to bear a
holistic and futuristic perspective to the balance sheet management. Banks
provide services that exposes them to various risks like credit risk, liquidity
risk, interest rate risk to name a few. It is therefore appropriate for banks to
focus on ALM when they face different types of risks.

There are different techniques used by banks for Asset Liability Management
and they are GAP analysis Model, Duration Gap analysis Model, Simulation
Model and Value at Risk.

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 Asset Liability Management in Banks

2. ASSET LIABILITY MANAGEMENT

As financial intermediaries banks are known to accept deposit to lend money

to entrepreneurs to make profit. They essentially intermediate between the
opposing liquidity needs of depositors and borrowers. In the process, they
function with an embedded mismatch between highly liquid liabilities on the
one side and less liquid and long term assets on the other side of their balance
sheets. Over and above this balance sheet conflict, they also stand exposed to
a wide array of risk such as market risk, transformation risk, credit risk,
liquidity risk, forex risk, legal risk, operation risk, reputational risk, interest
rate risk, etc. The recognition of three main risk i.e. Interest Rate Risk,
Liquidity Risk and Credit Risk gave rise to the concept of Asset Liability
Management.

Asset-Liability Management (ALM) can be termed as a risk management

technique designed to earn an adequate return while maintaining a
comfortable surplus of assets beyond liabilities. Banks are exposed to several
risks which are multi-dimensional. The main direct financial risks are interest
rate risk, liquidity risk, credit risk and market risk. The initial focus of the ALM
function would be to enforce the risk management discipline viz. managing
business after assessing the risks involved. The objective of good risk
management programmes should be that these programmes will evolve into a
strategic tool for bank management. The asset-liability management function
would involve planning, directing and controlling the flow, level, mix, cost and
yield of the consolidated funds of the Bank. It takes into consideration interest
rates, earning power, and degree of willingness to take on debt and hence is
also known as Surplus Management. It enables banks to sustain their required
growth rate by systematically managing market risk, liquidity risk, capital risk,
etc.

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 Asset Liability Management in Banks

The objective of ALM is to manage risk and not eliminate it. Risks and rewards
go hand in hand. One cannot expect to make huge profits without taking a
huge amount of risk. The objectives do not limit the scope of the ALM
functionality to mere risk assessment, but expanded the process to the taking
on of risks that might conceivably result in an increase in economic value of
the balance sheet.

Apart from managing the risks ALM should enhance the net worth of the
institution through opportunistic positioning of the balance sheet. The more
leveraged an institution, the more critical is the ALM function with enterprise.

The objectives of Asset-Liability Management are as follows:

 To protect and enhance the net worth of the institution.

 Formulation of critical business policies and efficient allocation of Capital.
 To increase the Net Interest Income (NII)
 It is a quantification of the various risks in the balance sheet and
optimizing of profit by ensuring acceptable balance between profitability,
growth and risks.
 ALM should provide liquidity management within the institution and choose
a model that yields a stable net interest income consistently while ensuring
liquidity.
 To actively and judiciously leverage the balance sheet to stream line the
management of regulatory capital.
 Funding of banks operation through capital planning.
 Product pricing and introduction of new products.
 To control volatility of market value of capital from market risk.
 Working out estimates of return and risk that might result from pursuing
alternative programs.

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3. COMPONENTS OF FINANCIAL STATEMENT

3.1 Balance Sheet

Liabilities

1. Capital: Capital represents owner’s contribution/stake in the bank. It

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

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Assets

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

For ALM these assets and liabilities are classified into different time periods
called maturity buckets, depending on maturity profile and interest rate
sensitivity. As per Reserve Bank of India guidelines issued for ALM
implementation in bank in 1999, there are eight time buckets T-1 to T-8
classified respectively as follows:

(i) 1 to 14 days
(ii) 15 to 28 days
(iii) Over 3 months and upto 6 months
(iv) Over 6 months and upto 1 year
(v) 1 year and upto 3 years
(vi) 3years and upto 5 years
(vii) Over 5 years

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Contingent Liabilities

Bank’s obligations under Letter of Credits, Guarantees, Acceptances on behalf

of constituents and Bills accepted by the bank are reflected under this heads.

3.2 Profit and Loss Account

Profit and Loss Account includes:

Income

1. Interest Earned: This includes Interest/Discount on Advances / Bills,

Income on Investments, Interest on balances with Reserve Bank of India
and other inter-bank funds
2. Other Income: This includes Commission, Exchange and Brokerage, Profit
on sale of Investments, Profit/(Loss) on Revaluation of Investments, Profit
on sale of land, buildings and other assets, Profit on exchange transactions,
Miscellaneous Income

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Expenses

1. Interest Expense: This includes Interest on Deposits, Interest on Reserve

Bank of India / Inter-Bank borrowings and others.
2. Operating Expense: This includes Payments to and Provisions for
employees, Rent, Taxes and Lighting, Printing and Stationery,
Advertisement and Publicity, etc.

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4. Rate Sensitive Assets & Rate Sensitive Liabilities

Those asset and liability whose interest costs vary with interest rate changes
over some time horizon are referred to as Rate Sensitive Assets (RSA) or Rate
Sensitive Liabilities (RSL). Those assets or liabilities whose interest costs do
not vary with interest rate changes over some time horizon are referred to as
Non Rate Sensitive Assets (NRSA) or Non Rate Sensitive Liabilities (RSL). It is
very important to note that the critical factor in the classification of time
horizon chosen. An asset or liability that is time sensitive in a certain time
horizon may not be sensitive in shorter time horizon and vice versa. However,
over a significantly long time horizon, virtually all assets and liabilities are
interest rate sensitive. As the time horizon is shortened, the rate of rate
sensitive to non rate sensitive assets and liabilities falls.

The table below shows the classification of the assets and liabilities of the bank
according to their interest rate sensitivity.

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5. RISK ASSOCIATED WITH ASSET LIABILITY MANAGEMENT

Risk can be defined as the chance or the probability of loss or damage. In the
case of banks these include credit risk, capital risk, market risk, interest rate
risk, liquidity risk, operations risk and foreign exchange risks. These categories
of financial risk require focus, since financial institutions like banks do have
complexities and rapid changes in their operating environments.

1. Credit Risk: The risk of counter party failure in meeting the payment
obligation on the specific date is known as credit risk. Credit risk
management is an important challenge for financial institutions and failure
on this front may lead to failure of banks. Credit risk plays a vital role in the
way banks perform. It reflects the profitability, liquidity and reduced Non
Performing Assets.

The other important issue is contract enforcement. Legal reforms are very
critical in order to have timely contract enforcement. Delays and loopholes
in the legal system significantly affect the ability of the lender to enforce the
contract. The legal system and its processes are notorious for delays
showing scant regard for time and money that is the basis of sound
functioning of the market system. Credit Risk Management is the process
that puts in place systems and procedures enabling banks to:
 Identify and measure the risk involved in credit proposition, both at
individual transaction and portfolio level.
 Evaluate the impact of exposure on bank’s financial statements.
 Access the capability of the risk mitigates to hedge/insure risks.
 Design an appropriate risk management strategy to arrest risk mitigation.

2. Capital Risk: Capital risk is the risk an investor faces that he or she may
lose all or part of the principal amount invested. It is the risk a company

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faces that it may lose value on its capital. The capital of a company can
include equipment, factories and liquid securities. Capital adequacy focuses
on the weighted average risk of lending and to that extent, banks are in a
position to realign their portfolios between more risky and less risky assets.

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

4. Interest Rate Risk: Banks in the past were primarily concerned about
adhering to statutory liquidity ratio norms and to that extent they were
acquiring government securities and holding it till maturity. But in the
changed situation, namely moving away from administered interest rate
structure to market determined rates, it becomes important for banks to
equip themselves with some of these techniques, in order to immunize
banks against interest rate risk.

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Interest risk is the change in prices of bonds that could occur as a result of
change: n interest rates. In measuring its interest rate risk, an institution
should incorporate re-pricing risk (arising from changing rate relationships
across the spectrum of maturities), basis risk (arising from changing rate
relationships among yield curves that affect the institution’s activities) and
optionality risks (arising from interest rate related options embedded in the
institution’s products).
There are certain measures available to measure interest rate risk. These
include:
 Maturity: Since it takes into account only the timing of the final principal
payment, maturity is considered as an approximate measure of risk and in
a sense does not quantify risk. Longer maturity bonds are generally
subject to more interest rate risk than shorter maturity bonds.
 Duration: Is the weighted average time of all cash flows, with weights
being the present values of cash flows. Duration can again be used to
determine the sensitivity of prices to changes in interest rates. It
represents the percentage change in value in response to changes in
interest rates.
 Dollar duration: Represents the actual dollar change in the market value
of a holding of the bond in response to a percentage change in rates.
 Convexity: Because of a change in market rates and because of passage
of time, duration may not remain constant. With each successive basis
point movement downward, bond prices increase at an increasing rate.
Similarly if rates increase, the rate of decline of bond prices declines. This
property is called convexity.

5. Liquidity Risk: Liquidity Risk is the risk stemming from the lack of
marketability of an investment that cannot be bought or sold quickly
enough to prevent or minimize a loss. It is usually reflected in a wide bid-
ask spread or large price movements. It arises from the potential inability
of the Bank to generate adequate cash to cope with a decline in deposits or

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increase in assets. To a large extent, it is an outcome of the mismatch in

the maturity patterns of assets and liabilities.

There are two types of liquidity i.e. market liquidity and funding liquidity.
Liquidity risk broadly comprises three sub-types:

 Funding Risk: The need to replace net outflows of funds whether due to
withdrawal of retail deposits or non-renewal of wholesale funds.
 Time Risk: The need to compensate for non-receipt of expected inflows
of funds, e.g. when a borrower fails to meet his repayment
commitments.
 Call Risk: The need to find fresh funds when contingent liabilities become
due. Call risk also includes the need to be able to undertake new
transactions when desirable.

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6. Purpose of Asset Liability Mismatch

ALM is no longer a standalone analytical function. There are micro and macro
level objectives of ALM.

At micro level, the objective functions of the ALM are two-fold. It aims at
profitability through price matching while ensuring liquidity by means of
maturity matching. Price matching basically aims to maintain spreads by
ensuring that the deployment of liabilities will be at a rate higher than the
costs. Similarly, liquidity is ensured by grouping the assets/liabilities based on
their maturing profiles. The gap is then assessed identify the future financing
requirements. This ensures liquidity. However, maintaining profitability by
matching prices and ensuring liquidity by matching the maturity levels is not
an easy task. The following tables explain the process involved in price
matching and maturity matching.

At macro-level, ALM leads to the formulation of critical business policies,

efficient allocation of capital and designing of products with appropriate pricing
strategies.

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7. ADDRESSING THE MISMATCHES

A key issue that banks need to focus on is the maturity of its assets and
liabilities in different tenors. A typical strategy of a bank to generate revenue
is to run mismatch, i.e. borrow short term and lend longer term. However,
mismatch is accompanied by liquidity risk and excessive longer tenor lending
against shorter-term borrowing would put a bank’s balance sheet in a very
critical and risky position.

To address this risk and to make sure a bank does not expose itself in
excessive mismatch, a bucket-wise (e.g. next day, 2-7 days, 7 days-1 month,
1-3 months, 3-6 months, 6 months-1 year, 1-2 year, 2-3 years, 3-4 years, 4-
5 years, over 5 year) maturity profile of the assets and liabilities is prepared to
understand mismatch in every bucket.

However, as most deposits and loans of a bank matures next day (call,
savings, current, overdraft etc.), bucket-wise assets and liabilities based on
actual maturity reflects huge mismatch; although all of the shorter tenor
assets and liabilities will not come in or go out of the bank’s balance sheet.

As a result, banks prepare a forecasted balance sheet where the assets and
liabilities of the nature of current, overdraft etc. are divided into ‘core and
non-core’ balances, where core is defined as the portion that is expected to be
stable and will stay with the bank; and non-core to be less stable. The
distribution of core and non-core is determined through historical trend,
customer behavior, statistical forecasts and managerial judgment; the core
balance can be put into over 1 year bucket whereas non-core can be in 2-7
days or 3 months bucket.

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An example of Forecasted balance can be as follows:

Assets Total Call 2D-7D 8D-1M 1M-3M 3M-1Y 1Y-5Y 5Y+

Reserve Assets 1,000 200 300 - - - 500 -
Interbank Placing 750 250 - 250 250 - - -
Assets 4,000 300 250 1,400 300 250 1,000 500
Other Assets 500 200 - - - - 300 -
Total Assets 6,250 950 550 1,650 550 250 1,800 500

Liabilities Total Call 2D-7D 8D-1M 1M-3M 3M-1Y 1Y-5Y 5Y+

Interbank Deposits -1,000 -750 - -250 - - - -
Other Deposits -4,500 -1,200 -1,000 -1,200 -100 -200 -800 -
Capital & Reserves -500 - - - - -100 -400 -
Other Liabilities -250 -250 - - - - - -
Total Liabilities -6,250 -2,200 -1,000 -1,450 -100 -300 -1,200 0

Off Balance Sheet Total Call 2D-7D 8D-1M 1M-3M 3M-1Y 1Y-5Y 5Y+
Commitments -2,000 - - - -150 -1,850 - -
Forward Contracts 250 - 100 50 100 - - -
Total Off Balance Sheet -1,750 0 100 50 -50 -1,850 0 0

Net Mismatch -1,750 -1,250 -350 250 400 -1,900 600 500

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8. Elements of Asset Liability Management

There are nine elements related to ALM and they are as follows:

1. Strategic framework: The Board of Directors are responsible for setting

the limits for risk at global as well as domestic levels. They have to decide
how much risk they are willing to take in quantifiable terms. Also it is
necessary to determine who is in chare of controlling risk in the
organization and their responsibilities.
2. Organizational framework: All elements of the organization like the ALM
Committee, sub–committees, etc., should have clearly defined roles and
responsibilities. ALM activities should be supported by the top management
with proper resource allocation and personnel committee.
3. Operational framework: There should be a proper direction for risk
management with detailed guidelines on all aspects of ALM. The policy
statement should be well articulated providing a clear direction for ALM
function.
4. Analytical framework: Analytical methods in ALM require consistency,
which includes periodic review of the models used to measure risk to avoid
miscalculation and verifying their accuracy. Various analytical components
like Gap, Duration, Stimulation and Value-at-Risk should be used to obtain
appropriate insights.
5. Technology framework: An integrated technological framework is
required to ensure all potential risks are captured and measured on a
timely basis. It would be worthwhile to ensure that automatic information
feeds into the ALM systems and he latest software is utilized to enable
management perform extensive analysis, planning and measurement of all
facets of the ALM function.
6. Information reporting framework: The information – reporting
framework decides who receives information, how timely, how often and in

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how much detail and whether the amount and type of information received
is appropriate and necessary for the recipient’s task.
7. Performance reporting framework: The performance of the traders and
business units can easily be measured using valid risk measurement
measures. The performance measurement considers approaches and ways
to adjust performance measurement for the risks taken. The profitability of
an institution comes from three sources: Asset, Liabilities and their efficient
management.
8. Regulatory compliance framework: The objective of regulatory
compliance element is to ensure that there is compliance with the
requirements, expectations and guidelines for risk – based capital and
liquidity ratios.
9. Control framework: The control framework covers the control over all
processes and systems. The emphasis should be on setting up a system of
checks and balances to ensure the integrity of data, analysis and reporting.
This can be ensured through regular internal / external reviews of the
function.

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9. THREE PILLARS OF ALM

The three pillars of Asset-Liability Management are as follows:

1. ALM Information Systems

2. ALM Organization

3. ALM Process

Pillar 1: ALM Information System

It includes Management Information System, Information availability,

accuracy, adequacy and expediency. A good information system gives the
bank management a complete picture of the bank's balance sheet. Considering
the large network of branches and the lack of an adequate system to collect
information required for ALM which analyses information on the basis of
residual maturity and behavioral pattern it will take time for banks in the
present state to get the requisite information. The problem of ALM needs to be
addressed by following an ABC approach i.e. analyzing the behavior of asset
and liability products in the top branches accounting for significant business
and then making rational assumptions about the way in which assets and
liabilities would behave in other branches. In respect of foreign exchange,
investment portfolio and money market operations, in view of the centralized
nature of the functions, it would be much easier to collect reliable information.
The data and assumptions can then be refined over time as the bank
management gain experience of conducting business within an ALM
framework. The spread of computerization will also help banks in accessing
data.

Pillar II: ALM Organization

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The board should have overall responsibility for the management of risks and
should decide the risk management policy of the bank and set the limits for
liquidity, interest rate, foreign exchange and equity price risk. The
responsibility of ALM is on the treasury department of the banks. The results
of balance sheet analysis along with recommendations is place in Asset
Liability Committee (ALCO) meeting by the treasurer where important
decisions are made are made to minimize risk and maximize returns. The Alco
committee comprising of the senior management of bank is responsible for
Balance Sheet risk management. The size of ALCO varies from organization to
organization. CEO heads the committee. The objective of the ALCO is to derive
the most appropriate strategy for the banks in terms of the mix of assets and
liabilities given its expectation for the future and the potential consequences of
interest-rate movements, liquidity constraints, foreign exchange exposure and
capital adequacy. It is the responsibility of the committee to ensure all
strategies conform to the bank’s risk appetite and levels of exposure as
determined by the Board Risk Committee.

Pillar3: ALM Process

The basic ALM processes involving identification, measurement and

management of risk parameter .The RBI in its guidelines has asked Indian
banks to use traditional techniques like Gap Analysis for monitoring interest
rate and liquidity risk. However RBI is expecting Indian banks to move
towards sophisticated techniques like Duration, Simulation, VaR in the future.
For the accrued portfolio, most Indian Private Sector banks use Gap analysis,
but are gradually moving towards duration analysis. Most of the foreign banks
use duration analysis and are expected to move towards advanced methods.

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10. ASSET LIABILITY COMMITTEE – ALCO

The Asset-Liability Committee (ALCO) consisting of the bank's senior

management including CEO should be responsible for ensuring adherence to
the limits set by the Board as well as for deciding the business strategy of the
bank (on the assets and liabilities sides) in line with the bank's budget and
decided risk management objectives.

The ALM desk consisting of operating staff should be responsible for analyzing,
monitoring and reporting the risk profiles to the ALCO. The staff should also
prepare forecasts (simulations) showing the effects of various possible
changes in market conditions related to the balance sheet and recommend the
action needed to adhere to bank's internal limits.

The ALCO is a decision making unit responsible for balance sheet planning
from risk-return perspective including the strategic management of interest
rate and liquidity risks. Each bank will have to decide on the role of its ALCO,
its responsibility as also the decisions to be taken by it. The business and risk
management strategy of the bank should ensure that the bank operates within
the limits/parameters set by the Board. The business issues that an ALCO
would consider, inter alia, will include product pricing for both deposits and
advances, desired maturity profile of the incremental assets and liabilities, etc.
In addition to monitoring the risk levels of the bank, the ALCO should review
the results of and progress in implementation of the decisions made in the
previous meetings. The ALCO would also articulate the current interest rate
view of the bank and base its decisions for future business strategy on this
view. In respect of the funding policy, for instance, its responsibility would be
to decide on source and mix of liabilities or sale of assets. Towards this end, it
will have to develop a view on future direction of interest rate movements and
decide on a funding mix between fixed vs floating rate funds, wholesale vs
retail deposits, money market vs capital market funding, domestic vs foreign

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currency funding, etc. Individual banks will have to decide the frequency for
holding their ALCO meetings.

Top Management, the CEO/CMD or ED should head the Committee. The Chiefs
of Investment, Credit, Funds Management/Treasury (forex and domestic),
International banking and Economic Research can be members of the
Committee. In addition the Head of the Information Technology Division
should also be an invitee for building up of MIS and related computerization.
Some banks may even have sub-committees.

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

Committee composition

Permanent members:

 Chairman
 Managing Director/CEO
 Financial Director
 Risk Manager
 Treasury Manager
 ALCO officer
 Divisional Managers

By invitation:

 Economist
 Risk Consultants

Purposes and Tasks of ALCO:

 Formation of an optimal structure of the Bank’s balance sheet to provide

the maximum profitability, limiting the possible risk level;
 Control over the capital adequacy and risk diversification;
 Execution of the uniform interest policy;

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 Asset Liability Management in Banks

 Determination of the Bank’s liquidity management policy;

 Control over the state of the current liquidity ratio and resources of the
Bank;
 Formation of the Bank’s capital markets policy;
 Control over dynamics of size and yield of trading transactions
(purchase/sale of currency, state and corporate securities, shares,
derivatives for such instruments) as well as extent of diversification
thereof;
 Control over dynamics of the basic performance indicators (ROE, ROA, etc.)
as prescribed in the Bank's policy.

10.1 Process of ALCO

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 Asset Liability Management in Banks

10.2 Organization Structure of ALCO

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11. ALM APPROACH

ALM in its most apparent sense is based on funds management. Funds

management represents the core of sound bank planning and financial
management. Although funding practices, techniques, and norms have been
revised substantially in recent years, it is not a new concept. Funds
management is the process of managing the spread between interest earned
and interest paid while ensuring adequate liquidity. Therefore, funds
management has following three components, which have been discussed
briefly.

1. LIQUIDITY RISK MANAGEMENT

Bank’s liquidity management is the process of generating funds to meet

contractual or relationship obligations at reasonable prices at all times. New
loan demands, existing commitments, and deposit withdrawals are the basic
contractual or relationship obligations that a bank must meet.

Liquidity Tracking

Measuring and managing liquidity needs are vital for effective operation of the
Company. By assuring the Company’s ability to meet its liabilities as they
become due, liquidity management can reduce the probability of an adverse
situation. The importance of liquidity transcends individual institutions, as
liquidity shortfall in one institution can have repercussions on the entire
system. The ALCO should measure not only the liquidity positions of the
Company on an ongoing basis but also examine how liquidity requirements are
likely to evolve under different assumptions. Experience shows that assets
commonly considered being liquid, such as govt. 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 requirement,

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 Asset Liability Management in Banks

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.

Analysis of following factors throws light on a bank’s adequacy of liquidity

position:
a. Historical Funding requirement
b. Current liquidity position
c. Anticipated future funding needs
d. Sources of funds
e. Options for reducing funding needs
f. Present and anticipated asset quality
g. Present and future earning capacity and
h. Present and planned capital position

To satisfy funding needs, a bank must perform one or a combination of the

following:
a. Dispose off liquid assets
b. Increase short term borrowings
c. Decrease holding of less liquid assets
d. Increase liability of a term nature
e. Increase Capital funds

Statement of Structural Liquidity

It Places all cash inflows and outflows in the maturity ladder as per residual
maturity. Maturity Liabilities are cash outflow and Maturity Assets are cash
inflows. The mismatches in the first two buckets cannot exceed 20% of
outflows. It shows the structure as of a particular date. Banks can fix the
tolerance level for other maturity buckets.

Assets and Liabilities to be reported as per their maturity profile into 8

maturity buckets:

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 Asset Liability Management in Banks

a. 1 to 14 days
b. 15 to 28 days
c. 29 days and up to 3 months
d. Over 3 months and up to 6 months
e. Over 6 months and up to 1 year
f. Over 1 year and up to 3 years
g. Over 3 years and up to 5 years
h. Over 5 years

An example of structural liquidity statement:

Outflow 1D-14D 15D-28D 30D-3M 3M-6M 6M-1Y 1Y-3Y 3Y-5Y 5Y+ Total
Capital - - - - - - - 200 200
Liab-fixed Int 300 200 200 600 600 300 200 200 2600
Liab-floating Int 350 400 350 450 500 450 450 450 3400
Others 50 50 - - - - 0 200 300
Total outflow 700 650 550 1050 1100 750 650 1050 6500

Inflow 1D-14D 15D-28D 30D-3M 3M-6M 6M-1Y 1Y-3Y 3Y-5Y 5Y+ Total
Investments 200 150 250 250 300 100 350 900 2500
Loans-fixed Int 50 50 0 100 150 50 100 100 600
Loans - floating int 200 150 200 150 150 150 50 50 1100
Loans BPLR Linked 100 150 200 500 350 500 100 100 2000
Others 50 50 0 0 0 0 0 200 300
Total Inflow 600 550 650 1000 950 800 600 1350 6500

Addressing the Mismatches

 Mismatches can be positive or negative
 Positive Mismatch: Maturing Assets > Maturing Liabilities
 Negative Mismatch: Maturing Liabilities > Maturing Assets

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 Asset Liability Management in Banks

 In case of positive mismatch, excess liquidity can be deployed in money

market instruments, creating new assets & investment swaps etc.
 For negative mismatch, it can be financed from market borrowings
(Call/Term), Bills rediscounting, Repos & deployment of foreign currency
converted into rupee.

Strategies
 To meet the mismatch in any maturity bucket, the bank has to look into
taking deposit and invest it suitably so as to mature in time bucket with
negative mismatch.
 The bank can raise fresh deposits of Rs 300 crore over 5 years maturities
and invest it in securities of 1-29 days of Rs 200 crores and rest matching
with other out flows.

2. ASSET MANAGEMENT

Many banks (primarily the smaller ones) tend to have little influence over the
size of their total assets. Liquid assets enable a bank to provide funds to
satisfy increased demand for loans. But banks, which rely solely on asset
management, concentrate on adjusting the price and availability of credit and
the level of liquid assets. However, assets that are often assumed to be liquid
are sometimes difficult to liquidate. For example, investment securities may be
pledged against public deposits or repurchase agreements, or may be heavily
depreciated because of interest rate changes. Furthermore, the holding of
liquid assets for liquidity purposes is less attractive because of thin profit
spreads. Asset liquidity, or how "salable" the bank's assets are in terms of
both time and cost, is of primary importance in asset management. To
maximize profitability, management must carefully weigh the full return on
liquid assets (yield plus liquidity value) against the higher return associated
with less liquid assets. Income derived from higher yielding assets may be

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offset if a forced sale, at less than book value, is necessary because of adverse
balance sheet fluctuations.

Seasonal, cyclical, or other factors may cause aggregate outstanding loans

and deposits to move in opposite directions and result in loan demand, which
exceeds available deposit funds. A bank relying strictly on asset management
would restrict loan growth to that which could be supported by available
deposits. The decision whether or not to use liability sources should be based
on a complete analysis of seasonal, cyclical, and other factors, and the costs
involved. In addition to supplementing asset liquidity, liability sources of
liquidity may serve as an alternative even when asset sources are available.

3. LIABILITY MANAGEMENT

Liquidity needs can be met through the discretionary acquisition of funds on

the basis of interest rate competition. This does not preclude the option of
selling assets to meet funding needs, and conceptually, the availability of
asset and liability options should result in a lower liquidity maintenance cost.
The alternative costs of available discretionary liabilities can be compared to
the opportunity cost of selling various assets. The major difference between
liquidity in larger banks and in smaller banks is that larger banks are better
able to control the level and composition of their liabilities and assets. When
funds are required, larger banks have a wider variety of options from which to
select the least costly method of generating funds. The ability to obtain
additional liabilities represents liquidity potential. The marginal cost of liquidity
and the cost of incremental funds acquired are of paramount importance in
evaluating liability sources of liquidity. Consideration must be given to such
factors as the frequency with which the banks must regularly refinance
maturing purchased liabilities, as well as an evaluation of the bank's ongoing
ability to obtain funds under normal market conditions.

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 Asset Liability Management in Banks

The obvious difficulty in estimating the latter is that, until the bank goes to the
market to borrow, it cannot determine with complete certainty that funds will
be available and/or at a price, which will maintain a positive yield spread.
Changes in money market conditions may cause a rapid deterioration in a
bank's capacity to borrow at a favorable rate. In this context, liquidity
represents the ability to attract funds in the market when needed, at a
reasonable cost vis-à-vis asset yield. The access to discretionary funding
sources for a bank is always a function of its position and reputation in the
money markets.

Although the acquisition of funds at a competitive cost has enabled many

banks to meet expanding customer loan demand, misuse or improper
implementation of liability management can have severe consequences.
Further, liability management is not riskless. This is because concentrations in
funding sources increase liquidity risk. For example, a bank relying heavily on
foreign interbank deposits will experience funding problems if overseas
markets perceive instability in U.S. banks or the economy. Replacing foreign
source funds might be difficult and costly because the domestic market may
view the bank's sudden need for funds negatively. Again over-reliance on
liability management may cause a tendency to minimize holdings of short-
term securities, relax asset liquidity standards, and result in a large
concentration of short-term liabilities supporting assets of longer maturity.
During times of tight money, this could cause an earnings squeeze and an
illiquid condition.

Also if rate competition develops in the money market, a bank may incur a
high cost of funds and may elect to lower credit standards to book higher
yielding loans and securities. If a bank is purchasing liabilities to support
assets, which are already on its books, the higher cost of purchased funds
may result in a negative yield spread.

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Preoccupation with obtaining funds at the lowest possible cost, without

considering maturity distribution, greatly intensifies a bank's exposure to the
risk of interest rate fluctuations. That is why banks that particularly rely on
wholesale funding sources, management must constantly be aware of the
composition, characteristics, and diversification of its funding sources.

12. Procedure for examining Asset Liability Management

In order to determine the efficacy of Asset Liability Management one has to

follow a comprehensive procedure of reviewing different aspects of internal
control, funds management and financial ratio analysis. Below a step-by-step
approach of ALM examination in case of a bank has been outlined.

Step 1

The bank/ financial statements and internal management reports should be

reviewed to assess the asset/liability mix with particular emphasis on: -

 Total liquidity position (Ratio of highly liquid assets to total assets).

 Current liquidity position (Minimum ratio of highly liquid assets to demand
liabilities/deposits).
 Ratio of Non Performing Assets to Total Assets.
 Ratio of loans to deposits.
 Ratio of short-term demand deposits to total deposits.
 Ratio of long-term loans to short term demand deposits.
 Ratio of contingent liabilities for loans to total loans.
 Ratio of pledged securities to total securities.

Step 2

It is to be determined that whether bank management adequately assesses

and plans its liquidity needs and whether the bank has short-term sources of
funds. This should include: -

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 Review of internal management reports on liquidity needs and sources of

satisfying these needs.
 Assessing the bank's ability to meet liquidity needs.

Step 3

The banks future development and expansion plans, with focus on funding and
liquidity management aspects have to be looked into. This entails: -

 Determining whether bank management has effectively addressed the

issue of need for liquid assets to funding sources on a long-term basis.
 Reviewing the bank's budget projections for a certain period of time in the
future.
 Determining whether the bank really needs to expand its activities. What
are the sources of funding for such expansion and whether there are
projections of changes in the bank's asset and liability structure?
 Assessing the bank's development plans and determining whether the bank
will be able to attract planned funds and achieve the projected asset
growth.
 Determining whether the bank has included sensitivity to interest rate risk
in the development of its long term funding strategy.

Step 4

Examining the bank's internal audit report in regards to quality and

effectiveness in terms of liquidity management.

Step 5

Reviewing the bank's plan of satisfying unanticipated liquidity needs by: -

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 Asset Liability Management in Banks

 Determining whether the bank's management assessed the potential

expenses that the bank will have as a result of unanticipated financial or
operational problems.
 Determining the alternative sources of funding liquidity and/or assets
subject to necessity.
 Determining the impact of the bank's liquidity management on net earnings
position.

Step 6

Preparing an Asset/Liability Management Internal Control Questionnaire which

should include the following: -

1. Whether the board of directors has been consistent with its duties and
responsibilities and included: -

 A line of authority for liquidity management decisions.

 A mechanism to coordinate asset and liability management decisions.
 A method to identify liquidity needs and the means to meet those needs.
 Guidelines for the level of liquid assets and other sources of funds in
relationship to needs.

2. Does the planning and budgeting function consider liquidity requirements?

3. Are the internal management reports for liquidity management adequate in

terms of effective decision making and monitoring of decisions.

4. Are internal management reports concerning liquidity needs prepared

regularly and reviewed as appropriate by senior management and the board
of directors.

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5. Whether the bank's policy of asset and liability management prohibits or

defines certain restrictions for attracting borrowed means from bank related
persons (organizations) in order to satisfy liquidity needs.

6. Does the bank's policy of asset and liability management provide for an
adequate control over the position of contingent liabilities of the bank?

7. Is the foregoing information considered an adequate basis for evaluating

internal control in that there are no significant deficiencies in areas not
covered in this questionnaire that impair any controls?

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13. Regulatory Framework

The central bank of a country has to ensure that in its drive for profitability
and market share the banking sector does not expose itself and by extension
the market to high levels of risk. Credit risk traditionally has been and still is
the biggest risk faced by this sector and has been addressed through various
central bank relations and guidelines.

The RBI has already come out with guidelines governing market risk including
the need for banks to constitute an ALCO. However, given the state of data
availability most bank ALCOs are not able to hold meaningful discussions on
balance sheet risks. Discussions in most ALCOs that do meet regularly are
oriented towards treasury activity rather than taking a view of the entire
balance sheet. This is again mainly due to lack of data on the other businesses
of the bank. However, given the increasing volatility in interest and exchange
rates it is becoming critical for banks to manage their market risks. It is
therefore likely that the RBI would introduce more detailed guidelines for ALM.
A look at the regulatory guidelines in the more developed markets on ALM
could provide clues to the main features of any guidelines that may be
introduced by the RBI.

1. As a measure of liquidity management, banks are required to monitor their

cumulative mismatches across all time buckets in their Statement of Structural
Liquidity by establishing internal prudential limits with the approval of the
Board / Management Committee. As per the guidelines, the mismatches
(negative gap) during the time buckets of 1-14 days and 15-28 days in the
normal course are not to exceed 20 per cent of the cash outflows in the
respective time buckets.

2. Having regard to the international practices, the level of sophistication of

banks in India and the need for a sharper assessment of the efficacy of

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liquidity management, these guidelines have been reviewed and it has been
decided that :

(a) The banks may adopt a more granular approach to measurement of

liquidity risk by splitting the first time bucket (1-14 days at present) in the
Statement of Structural Liquidity into three time buckets viz. Next day, 2-7
days and 8-14 days.

(b) The Statement of Structural Liquidity may be compiled on best available

data coverage, in due consideration of non-availability of a fully networked
environment. Banks may, however, make concerted and requisite efforts to
ensure coverage of 100 per cent data in a timely manner.

(c) The net cumulative negative mismatches during the Next day, 2-7 days, 8-
14 days and 15-28 days buckets should not exceed 5 %, 10%, 15 % and
20 % of the cumulative cash outflows in the respective time buckets in
order to recognize the cumulative impact on liquidity.

(d) Banks may undertake dynamic liquidity management and should prepare
the Statement of Structural Liquidity on daily basis. The Statement of
Structural Liquidity, may, however, be reported to RBI, once a month, as
on the third Wednesday of every month.

3. The format of Statement of Structural Liquidity has been revised suitably and
is furnished at Annex I. The guidance for slotting the future cash flows of
banks in the revised time buckets has also been suitably modified and is
furnished at Annex II. The format of the Statement of Short-term Dynamic
Liquidity may also be amended on the above lines.

4. To enable the banks to fine tune their existing MIS as per the modified
guidelines, the revised norms as well as the supervisory reporting as per the
revised format would commence with effect from the period beginning January
1, 2008 and the reporting frequency would continue to be monthly for the

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present. However, the frequency of supervisory reporting of the Structural

Liquidity position shall be fortnightly, with effect from the fortnight beginning
April 1, 2008.

14. ISSUES IN IMPLEMENTATION OF ALM

1. Policy: Lack of a coherent, documented and practical policy is a big hindrance

to ALM implementation. Most often, ALCO membership itself may not be aware
of implications of risks being measured and impact. Policies should address all
issues concerning the bank, all policies should be clearly explained to all
members of board, apart from ALCO and these must be documented. Proper
revisions to this document, a quarterly review needs to be organized as well
as parameters may be changing due to change in situations.
2. Understanding of complexities: Many people in a bank need to understand risk
measurements and risk mitigation procedures. Measurement of risk is a fairly
simple phenomenon and does go on regardless. Formalization of
understanding, especially at a top level, will be helpful as it would help in
decision –making.
3. Organization and culture: ALM function needs to be separated clearly from
operations as it involves control and strategy functions. Risk organization in
banks generally land up reporting to treasury, as they are people who come
closest to understanding complex financial instruments. The fact that they are
a business unit, in charge of ‘risk taking’ is overlooked. ‘Risk Taking’ and ‘Risk
management’ are generally two distinct parts of any organization and both
must report to a board completely independently. Openness and transparency
are essential to a proper risk organization. Most organizations react badly to
some positions going wrong by taking more risks and enter vicious cycle of
risks. Thus, it is required to follow policy implicitly in both letter and spirit.
4. Data and Models: Data may not be available at all times in requisite format. It
must be remembered that many data items are assumptions and gaps must
be measured in perspective. There was a case of a manual branch of a bank

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that was closed for 6 months in a year due to inclement weather and was
largely inaccessible. As data may not be obtained from this branch for 6
months, appropriate assumptions have to be made in any event. The
argument is that for all other purposes, assumptions are being made. Sensible
options need to be chosen and manual branch without computer was an
example. However, in modern banking, it is mapping of models to zero coupon
bonds that are an issue. Once again, arguments are that this should exist
within the bank. Based on sophistication required, multiple models may be
used to validate this conversion. This is strictly outside ALM framework but
integrates into ALM framework.
5. Unrealistic goals: An ALCO secretary was seen desperately trying to tweak
with parameters to ‘show’ less gaps in liquidity reports. A zero gap is not
practical. Returns are expected for taking risks. Banks assume market and
credit risk and hence they make returns. ALCO’s job is to correctly determine
positions and put in place appropriate remedial measures using appropriate
risks. It is not to show things as good when they are not.

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15. TECHNIQUES OF ASEET LIABILITY MANAGEMENT

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

Changes in Changes in Changes in

GAP Change in
Interest Interest Interest
Position NII
Rates Income Expense
Positive Increase Increase Increase Increase
Positive Decrease Decrease Decrease Decrease
Negative Increase Increase Increase Decrease
Negative Decrease Decrease Decrease Increase
Zero Increase Increase Increase None
Zero Decrease Decrease Decrease None

Positive gap indicates a bank has more sensitive assets than liabilities and the
NII will generally rise (fall) when interest rate rises (fall)
Negative gap indicates a bank has more sensitive liabilities than assets and
the NII will generally fall (rise) when interest rates rise (fall)

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It measures the direction and extent of asset-liability mismatch through either

funding or maturity gap. It is computed for assets and liabilities of differing
maturities and is calculated for a set time horizon. This model looks at the
repricing gap that exists between the interest revenue earned and the bank's
assets and the interest paid on its liabilities over a particular period of time. It
is sometimes referred to as periodic gap because banks use gap analysis
report to measure the interest rate sensitivity of RSA and RSL for different
periods. These periods are known as maturity buckets which vary across
banks, depending on the operating strategy.

Positive Gap Negative Gap

Rate Sensitive Assets are more than Rate Sensitive Liabilities are more
Rate Sensitive Liabilities than Rate Sensitive Assets
Assets mature before Liabilities Liabilities mature before Assets
Short-term assets funded with long- Long-term assets funded with short-
term liabilities term liabilities
If interest rate increase, NII also If interest rate increase, NII also
increase decrease

Assumptions
 Contractual Repayment Schedule i.e. no early repayment or option like
feature
 On Schedule Payments i.e. there is no early repayments or defaults
 Parallel Shift in Yield Curve i.e. both short-term and long-term interest rate
change by the same amount.

Advantages
 Simple to analyze
 Easy to implement
 Helps in future analysis of Interest Rate Risk
 Helps in projecting the NII for further analysis
Limitations

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 Asset Liability Management in Banks

 It does not incorporate future growth or changes in the mix of assets and
liabilities.
 It in not take time value of money or initial net worth into account.
 The periods used in the analysis are arbitrary and repricing is assumed to
occur at the midpoint of the period.
 It does not provide a single reliable index of interest rate.

Example of GAP

ABC bank for which maturity Pattern of assets and liabilities as on a particular
date i.e. 31st December 2009

Here, Rs. 705.55 Cr in the deposit liability of deposits means that as on

December 31st, 2009 the bank was liable to repay this amount including the
interest during the next 14 days on account of the deposits received by the
bank till date. Similarly, Rs. 376.05 Cr in the loans and advances indicates as
on 31st December 2009 the bank was expected to get back this amount during
the next 14 days of the loans and advances it has given till date.

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Results
ΔNII = GAP
RSL = RSA = GAP = GAP Ratio
Maturity Cumulative ΔI (for ΔI =
Total Total RSA - =
Buckets GAP 0.25%
Outflows Inflows RSL RSA/RSL
decrease)
1D - 14D 758.80 525.65 -233.15 -233.15 0.69 0.58
15D-28D 410.03 153.79 -256.24 -489.39 0.38 1.22
29D-3M 1,708.40 624.49 -1,083.91 -1,573.30 0.37 3.93
3M-6M 1,824.53 943.31 -881.22 -2,454.52 0.52 6.14
6M-1Y 3,984.10 1,237.60 -2,746.50 -5,201.02 0.31 13
1Y-3Y 7,058.26 6,141.30 -916.96 -6,117.98 0.87 15.3
3Y-5Y 3,809.60 3,492.62 -316.98 -6,434.96 0.92 16.09
5Y+ 6,085.70 11,928.96 5,843.26 -591.70 1.96 1.48

Observations

From the results GAP amount is negative till 3-5 year period and positive for
the last period, which means ABC bank can be grouped as liability sensitive.
Long-term assets are funded with short-term liabilities and the bank will
benefit as NII increases with decrease in interest rates a shown in the above
table for a decrease in the rate of interest of 0.25%. Cumulative GAP amount
is also negative for all time periods. GAP ratio is between 0.3 and 0.92 up to
3-5 year period indicating that inflows are always less than outflows and for
the last time period inflows are double the outflows.

To reduce Rate Sensitivity

Buy long-term securities, lengthen the maturities of loan and convert floating
rate loans to term loans.

To increase Asset Sensitivity

Buy short-term securities, shorten the maturities of loan and convert term
loans to floating rate loans.

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To reduce Liability Sensitivity

Pay premium to attract long-term deposits and issue ling-term subordinated

debt.

To increase Liability Sensitivity

Pay premium to attract short-term deposits and borrow more non-core

purchased liability.

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

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Advantages

 Duration Gap analysis serves as a strategic tool for evaluating and

controlling interest rate risk.
 It improves the maturity gap and cumulative gap models by taking into
account the timing and market value of cash flows rather them time
maturity.
 It offers flexibility in spread management.
 Instead of changing the maturity structure of assets and liabilities,
Duration Gap analysis puts emphasis on change of mix of assets or
liabilities whichever is feasible.

Limitations

 It requires extensive data on specific characteristics and current market

pricing schedules of financial instruments.
 It requires high degree of analytical expertise regarding issues such as
term structure of interest rates and yield curve dynamics.

15.3 Simulation Analysis: It analyzes the interest-rate risk arising from both
current and planned business. Gap analysis and duration analysis as stand-
alone tool for asset-liability management suffer from their inability to move
beyond the static analysis of current interest rate risk exposures. Basically
simulation models utilize computer power to provide what if scenarios.
What if:
 The absolute level of interest rate shift
 There are non parallel yield curve changes
 Marketing plans are under-or-over achieved
 Margins achieved in the past are not sustained/improved
 Bad Debts and prepayment levels change in the different interest rate
scenarios

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 There are changes in the funding mix e.g. an increasing reliance on short-
term funds for balance sheet growth.
 Accurate evaluation of current exposures of asset and liability portfolios to
interest rate risk.
 Changes in multiple target variables such as NII, Capital adequacy and
liquidity.

There are certain criteria for the simulation model to succeed. These pertain to
accuracy of data and reliability of the assumptions made. In other words, one
should be in a position to look at alternatives pertaining to prices, growth
rates, reinvestments, etc., under various interest rate scenarios. This could be
difficult and sometimes contentious. it is also to be noted that the managers
might not want to document their assumptions and data is not easily available
for differential impacts of interest rates on several variables. Hence, simulation
models need to be used with the caution. The use of simulation model calls for
commitment of substantial amount of time and resources.

Assumptions
 Expected changes and the levels of interest rates and the shape of yield
curve
 Pricing strategies for assets and liabilities
 The growth, volume and mix of assets and liabilities

Advantages

 It is easy to approximate very complex and discounted payoffs

 It is very flexible
 It can incorporate multiple time periods
 It captures majority of the option risk

Limitations

 It is computationally intensive
 It requires maintenance of pricing models

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

Advantages
 Translates portfolio exposures into potential profit and loss
 Aggregates and reports multi-product, multi-market exposures into one
number
 Uses risk factors and correlations to create a risk weighted index
 Monitors VAR limits
 Meets external risk management disclosures and expectations.

Limitations

 This study is useful only for normal operative accounts to predict their
probability of default.
 This model does not take already defaulted customers into account.
 Macro level changes in an industry, changes in government policies, etc.,
may result in distorted results.
 In this methodology if the VAR measurement is for shorter duration, the
risk assessment is more accurate.

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16. GAP AND NII

ALM is heavily dependent on the movements of interest rates in the market. It

builds up Assets and Liabilities of the bank based on the concept of Net
Interest Income (NII) or Net Interest Margin (NIM). Even though maturity
dates are same, if there is a mismatch between amount of assets and
liabilities it causes interest rate risk and affects NII.

Factors affecting NII

 Changes in the level of interest rates

 Changes in the composition of assets and liabilities

 Changes in the volume of earning assets and interest-bearing liabilities

outstanding

 Changes in the relationship between the yields on earning assets and rates
paid on interest-bearing liabilities

Example

NII = (Yield x Assets) – (Cost x Liabilities)

NII = (0.08 x 500 + 0.11 x 350) - (0.04 x 600 + 0.06 x 220)

NII = 78.5 - 37.2 = 41.3

NIM = 41.3/850 = 4.86%

GAP = 500 – 600 = -100

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 Asset Liability Management in Banks

Impact of changes

1% increase in short time rates

NII = (0.09 x 500 + 0.11 x

350) - (0.05 x 600 + 0.06 x 220)

NII = 83.5 - 43.2 = 40.3

NIM = 40.3 / 850 = 4.74%

GAP = 500 - 600 = -100

With a negative gap, more liabilities than assets reprice higher; hence NII &
NIM fall

1% decrease in spreads

NII = (0.085 x 500 + 0.11 x 350) - (0.055 x 600 + 0.06 x 220)

NII = 81 - 46.2 = 34.8

NIM = 34.8 / 850 = 4.09%

GAP = 500 - 600 = -100

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 Asset Liability Management in Banks

NII & NIM fall (rise) with a decrease (increase) in the spread. This is because,
if liabilities are short-term and assets are long-term, the spread will widen as
the yield curve increases in slope and narrow when the yield curve decreases
in slope and/or inverts.

Proportionate doubling in size

NII = (0.08 x 1000 + 0.11 x

700) - (0.04 x 1200 + 0.06 x 440)

NII = 157 - 74.4 = 82.6

NIM = 82.6 / 1700 = 4.86%

GAP = 1000 - 1200 = -200

NII & GAP doubled, but NIM remains the same.

Net interest income varies directly with the changes in the volume of earning
assets and interest bearing liabilities, regardless of the level of interest rates.

If RSA increase, fixed assets decrease and RSL decrease, fixed liabilities
increase

Particulars Assets Yield Liabilities Cost

Rate sensitive 540 8% 560 4%
Fixed rate 310 11% 260 6%
Non earning 150 - 100 -
Equity - - 80 -
Total 1000 1000

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 Asset Liability Management in Banks

NII = (0.08 x 540 + 0.11 x 310) - (0.04 x 560 + 0.06 x 260)

NII = 77.3 - 38 = 39.3
NIM = 39.3 / 850 = 4.62%
GAP = 540 - 560 = -20
Although the banks GAP is lower the banks NII is also lower.
Changes in portfolio composition and risk
 To reduce risk, a bank with a negative GAP would try to increase RSAs
(variable rate loans or shorter maturities on loans and investments) and
decrease RSLs (issue relatively longer - term CDs and fewer fed funds
purchased).
 Changes in portfolio composition also raise or lower interest income and
expense based on the type of change.

Summary of GAP and NII

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BIBLIOGRAPY

 Asset Liability Management in Banks – ICFAI

 Bank Financial Management – Indian Institute of Banking and Finance

 www.rbi.org

 www.investopedia.com

 www.allbankingsolutions.com

 www.iibf.org.in

 www.fimmda.org

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