sset and liability management (ALM) is a practice used by financial institutions to mitigate financial risks resulting from a mismatch of assets and liabilities. ALM strategies employ a combination of risk management and financial planning and are often used by organizations to manage long-term risks that can arise due to changing circumstances.

1. ASSET- LIABILITY
MANAGEMENT IN
COMMERCIAL
BANKS

2. EVOLUTION OF ASSET- LIABILITY
MANAGEMENT(ALM) APPROACH
 The overall success of banks and financial institutions
in a competitive and market driven environment
hinges essentially on how effectively they discharge
their intermediation operations to obtain maximum
yield.
 In a regimented and controlled environment the
interest spread is primarily a function of central bank.

3.  This, however, does not happen in a deregulated
environment.
Intense competition for business and increasing
fluctuations in both domestic interest rates as well
as foreign exchange rates put pressure on the
management of banks to maintain spreads,
profitability and long-term viability without
increasing market risk.

4. Types of Risks
There are two major types of risks that a
commercial bank is exposed to in the course
of its operations
1) Credit risk
2) Market risk

5.  Market risk arising out of fluctuations in
interests rates, foreign exchange rates,
equity price risk and commodity price risk is
virtually not existent in such a regime where
market rates and prices are stable.
 Banks have to manage not only credit risk
but also market risk. They require a
managerial approach to control the viability
of market risk.

6.  ALM as a discipline is nearly three decades
old in the developed and deregulated
western world.
 3-6-3 banking was a standing joke in the
USA on thrift managers during 60 and early
70.
 So in regulated environment, more the
deposits, more the loans and more the
spread.

7.  Deregulation of interest rates in 80s saw the
demise of 3-6-3 banking, giving blow to S & L
debacle which had cost the US tax payers a
couple of hundred billion USD
 With the technological changes in Indian
economic policy in early 90s leading to
deregulation of interest rates and free play of
market forces, entry of new players, emergence
of new financial instruments and new products
at competitive rates and enhancement of risks,
and income recognition and provisioning
commercial banks in our country began to face
tremendous problem of asset-liability miss-
match.

8.  Banks and financial institutions, which ignored
ALM, were caught in a severe asset-liability mis-
match in 1997-98.
 With growing tendency of greater integration of
money market, foreign exchange market and
capital market and greater volatility in the market
condition with the emergence of an active debt-
market, Indian commercial banks will be more
under pressure to adopt the new approach so as to
emerge as active players in the market.

9. Concept of ALM
 ALM is an integrated strategic managerial
approach of managing total balance sheet
dynamics having regard to its size and quality
in such a way that the net earnings from
interest in particular are maximized with the
overall risk preference of the of the institution.
This approach is concerned with the net
interest margin to ensure that its level and
riskiness are compatible with the risk-return
objectives of the bank.

10.  The maturity mismatches and
disproportionate changes in the level of assets
and liabilities can cause financial liquidity and
interest rate risks. The degree of mismatch
may be very high in most banks. This is
because banks fund their long-term assets
with the short term liabilities.
 Mismatch is also caused by a bank’s lending
substantial portion of liabilities by way of cash
credit amounting to 70% of the total advances.

11.  Further, a bank’s investment in government
securities – both central and state are for a
period of 10 to 15 years whereas funds
received are of shorter maturities.
 ALM approach involves quantification of
risk and conscious decision- making with
regard to asset- liability.
 ALM can, therefore , be defined as the
process of managing the net interest margin
within the overall risk bearing capacity of a
bank.

12. The secret of effective banking
deregulated and competitive
environment hinges essentially on
matching of assets and liabilities in term
of rate and maturity with a view to
deriving optional yield.
ALM has to be closely integrated with
business strategy of the bank as the
latter has bearing upon the risk profile
of the bank.

13. Thus the focus of ALM is not on
building up of deposits and loan/
assets in isolation but on net interest
income and recognizing interest rate
and liquidity risks.

14. Diagrammatic
presentation of ALM and
asset- liability mis-
matches is brought out in
the following charts:

15. Asset – Liability Management Structure

16. OBJECTIVES OF ASSET- LIABILITY MANAGEMENT
Primary objective of ALM is to
manage risk in such a way as to
minimize the impact of net interest
income fluctuations in short run and
protect the net economic value of the
bank in the long run.

17. ALM has the following objectives:
to control the volatility of net interest
income and net economic value of a
bank.
to control volatility in all target accounts
to control liquidity risk, and
to ensure an acceptable balance between
profitability and growth rate.

18. FUNCTIONS OF ASSET-
LIABILITY MANAGEMENT
 To guide the management in
establishing optimal match
between the assets and liabilities of
the bank in such a way as to
maximize its net income and
minimize the market risk.

19.  The bank manager equipped with the
interest rates related information about
existing profile of bank can reduce its future
risk by marketing its long term deposit
products more aggressively and whenever
necessary even by increasing the rates on
long-term deposit and/ or decreasing rates
offered on the short-term deposits.

20. The main focus of asset liability
management, in a nutshell, is the
matching of the liabilities and assets in
terms of maturity, cost and yield rates.

21.  ALM approach comprises the following
aspects:
 Review of interest rate scenario.
 Fixation of interest / product pricing on both assets
and liabilities.
 Assessment of existing investment portfolio.
 Assessment of existing loan portfolio.
 Measurement of financial rate.
 Review of actual performance vis-à-vis projection in
respect of net profit, interest spread and other
balance sheet ratio.
 Strategic planning and budgeting.
 Examining profitability of new products.

22. PROCESS OF ASSET-LIABILITY
MANAGEMENT
Strategic approach to manage asset-liability and for
that purpose to measure, manage and monitor
the financial risk involves four stages:
 Identification of risks.
 Measurement and determination of risks.
 Enhancement of long-term profitability for a
given level of risks.
 Management of risks.

23. IDENTIFICATION OF RISKS
 The first step to ALM in a bank is identification
of various types of financial risks a bank is
exposed to. It is, therefore, imperative to
comprehend each of these risks and find out how
they arise.
 There are five kinds of financial risks, viz., Credit
risk, Interest rate risk, Liquidity Risk, Capital
Risk and Market Risk. Credit risk arises when the
counterparty fails to perform the repayment
obligation on due date.

24.  In a highly volatile interest rate environment
loan defaults may increase, thereby
deteriorating the credit quality.
 Interest rate risk means risk resulting from
changes in the interest income owing to interest
rate fluctuations.
 Liquidity risk is the potential inability to
generate cash to cope with the decline in
deposits or increase in assets.

25.  Capital risk arises from the inadequacy of capital
of a bank to cope with statutory as well as
business requirements.
 Another kind of financial risk is market risk that
results from adverse movement in market prices.
Primarily the impact of market prices is
observed in the movement of portfolio values.
There exists strong relationship between interest
rate and market risk variables. Inadvertently
taken, market risk could prove to be dangerous
for banks.

26. Measurement of Risk
 It would be pertinent to decide what should be
the risk measurement parameters that the
management would need to focus on.
 The risk parameters chosen should be capable of
capturing the risk to the immediate profitability
as well as the risk to the long-term viability i.e
future spreads between balance sheet values and
economic capital adequacy, with changes in
interest/ exchange rates.

27.  Generally, there are two major parameter which
banks across the globe employ to measure their
balance sheet risks, viz., risk to the Net Interest
Income and Market Value of Portfolio Equity.
 The former seeks to measure the risk to
immediate profits that emanate from cash flow
mis-matches occurring in the accounting year.
 There are several methods to measure interest
rate risk, important being Gap method, Duration
Method, Simulation and Value at risk Method.

28. Gap Method
 It measures the difference between a bank’s assets and
liability and off-balance sheet positions which will be
repriced or will mature within a pre-determined
period. In other words, this technique measures the
difference between the absolute value of rate sensitive
assets and rate sensitive liability over a gapping period
.

29.  However, the rate sensitive gap can be
mathematically expressed as:
RSG = RSA/ RSL
Where RSG = Rate Sensitive Gap
RSA = Rate Sensitive Asset
RSL = Rate Sensitive Liabilities

30.  Ratio of one indicates perfect match of rate
sensitive assets to liabilities. If spread is
positive at the beginning of the period, this
perfect match protects the same even in the
wake of subsequent changes in the interest
rate. If the ratio is greater than one, higher
income is produced with increase in interest
rates . Ratio of less than one produces
higher losses with fall in interest rates.

31. Duration method
This method attempts to assess the
effects of interest rate changes on the
market value of assets and liabilities of
the bank.

32. Simulation
Simulation model attempts to analyse
the impact of changes in interest rates
on the net income under different
interest rate and market price
scenarios.

33. Value at Risk Method
To workout depreciation / appreciation
in the value of assets/ liabilities
because of change in interest rate with
a view to indicating the trend in
economic values of portfolio.

34. Enhancement of Long-term
Profitability
 The third stage of ALM process is identification of
favourably priced assets/ liabilities and off-balance sheet
items so as to enhance long-term profitability for a given
level of risk.
 They should resist the temptation of accession to easily
found high priced liabilities.
 Every effort should be made to find low price liabilities.
 Mis-matches are usually built in client markets as assets
and liabilities are created sequentially but not
simultaneously and the same are managed in financial
market.

35. Management of Risk
 For effective management of financial risk of
bank, the Board of Directors should formulate
overall investment policy, liquidity policy and
policy regarding financing. It should also
determine the acceptable level of risk in terms of
the parameters chosen.
 It involves managing the CRR and SSR for the
banks as a whole, formulating schemes having
refinance facilities to have better leverage in
managing the asset-liability and as a spin- off
earning better profit.

36.  While formulating plan, the management should
focus on products and services that are made
available to branches which have special advantage
like acquiring funds at low cost, providing services
which do not entail funds outflow but result in
additional income, schemes which provide for
faster recycling of funds.
 The Board should also determine how frequently
risks are to be monitored keeping in view the
availability of data, fluctuation of interest and
exchange rates and the pace of changing of the risk
profile of the bank’s balance sheet.

37.  Banks should set up an Asset-Liability
Management Committee (ALCO) . ALCO consists
of the banks senior management with CEO as its
head has to be responsible for drawing up
strategic plans for the banks assets-liability.
 The ALCO has to address crucial issues like
product pricing for both deposits and loans, the
desired maturity profile of incremental assets-
liabilities, the extent of exposure in long-dated
governments securities, the impact of a large
business deal on the banks risk profile, etc.

38.  For better planning and implementation, it will
be advisable for banks to constitute sub-
committees to handle certain important activities
such as credit, investment , liability, etc.
 Strategic planning exercise should also be done at
the branch level.
 A robust mechanism needs to be built in so as to
enable constant monitoring by the senior
management of the risk parameters and to ensure
adherence to policy limits.

39. PREREQUISITES TO THE
EFFECTIVENESS OF ALM
 The ALM presupposed the team approach in
decision- making and action. This implies
involvement of all functionaries of the Bank.
 Visualization of the bank’s vision and its
articulation in terms of purpose and mission is
the hallmark of ALM. Vision not only provides
driving fuel, direction to the ALM strategy, but
also helps the management in evaluating the
practices and making prudent decision.

40.  The top management should evolve a system to
provide to all levels of management through
understanding and awareness of risk and all its
parameters.
 Technological and infrastructural support
system in the bank would be an important
prerequisite to implement effectively the ALM
system.
 Therefore, essential to install an appropriate
software.

41.  An appropriate software model would be able to
correctly reflect the risk profile of the bank’s products on
both the assets and liability side,
 ALM system must continually be reviewed and its results
appraised so as to conform that the standards set are
being achieved.
 A schedule of liquidity reviews should be provided for so
as to re-examine and refinance the bank’s liquidity
policies and practices keeping in view the bank’s
liquidity experience and development in the business.
 The bank must develop human resource and craft a well
thought out strategy for development skills and
competence of its functionaries for risk definition.

42. RELEVANCE OF ALM TO
COMMERCIAL BANKS IN INDIA
 Keeping in view the imperativeness of the adoption of the
ALM system in the resolution of the problems facing the
Indian banks, RBI vide its circular dated Feb 12, 1998
advised commercial banks to tighten their assets-liability
management and put in place an appropriate system of
asset-liability management. It suggested parameters based
on time buckets and the sensitivity of both deposits and
advances to interest rate fluctuation.
 RBI has also decided to test a model on the few leading
banks, whereby banks have been asked to furnish data in a
format outlined by it.

43. As a general rule RBI guidelines provided that:-
 20-25% of the demand deposits, including saving be
considered as withdrawable on the demand and shown
under the 1/14 day time bucket.
 Banks should study the behavioural pattern of deposits
on the basis of historical trend and based on this, banks
should classify the deposits into volatile and core
portions. While volatile portion is in the 1-14 day bucket.
the core portion should be placed in the one –two year
bucket. The term deposits will fit into the respective
maturity bucket , a saving bank deposit is sensitive to
interest payment and repricirng is possible only when
RBI changes the rates while announcing the monetary
policy.

44.  NPA, net of provisions should be shown under
the two to five-year bucket and sub-standard
assets in one to two-year buckets.
 Banks should study the behavioural and seasonal
pattern of drawal in credit, based on outstanding,
the core and volatile portion should be identified.
 Excess balance over the required CRR and SLR
shown under 1-14 day bucket. The statutory CRR
balances may be distributed under various time
buckets corresponding to the DTL placed in their
buckets with a time lag of 14 days.

45.  For borrowing on floating rate, the amount
should be distributed to the appropriate bucket
which refers to the repricing date while for the
zero campus, it should be distributed to the
maturity bucket relating to the matter of April
and October, since the reprice is done only when
RBI changes rates.
 The RBI advised banks in February, 1999 to put in
place an ALM system, effective April 1, 1999 and
set up internal Assets-liability Management
Committee. (ALCos) at the top management level
to oversee its implementation.

46. The Reserve Bank also released ALM
system guidelines in January 2000 for
all India term-lending and refinancing
institutions, effective from April 1,
2000.

47.  During the last three years (2004-2007),
commercial banks in India have been facing
serious asset-liability mis-match, for the fact that
while more and more bank credits are going for
infrastructure lending and commercial real estate
financing, the liability structure of the bank is
getting shorter and shorter due to heavy reliance
on bulk deposits. Most of the bulk deposits are
from insurance companies, money market
mutual funds, state governments and large
corporate and these deposits were mopped for
tenures upto a year by offering rates upto 11.4 per
cent.

48.  So as to ensure that banks put in place a
sound system of assets-liability
management and thereby instill more
discipline among banks in managing their
liquidity, the RBI issued the following new
guidelines on September, 2007.

49.  Banks are not permitted to have a negative gap in their
funds outflow for the next day. Negative gap refers to
mismatch in which interest- sensitive liabilities exceed
interest-sensitive assets.
 Banks must adopt a more granular approach to
measurement of liquidity risk by splitting the first time
bucket of 1-14 days in the statement of structural liability
into three times buckets-next day, 2-7 days and 8-14 days
.The net cumulative negative mismatch during the next
day, 2-7 days 8-14 days and 15-28 days should not exceed
5 percent, 10 percent, 15 percent and 20 percent of the
cumulative cash outflow in the respective buckets in
order to recognize the cumulative impact on liquidity.

50.  Banks are required to report this data to the RBI
on fortnightly basis.
 Banks can finance the gap from call money
market, bill rediscounting, repos and deployment
of foreign currency resources after conversion
into rupees.
 The new norms will be implements from 1st
January, 2008. this gave banks time to fine –time
thus existing management information system.