Every bank holds cash balances to meet its customers’ requests for withdrawalMONEY AT CALL AND SHORT NOTICE :These are short term loans ( between 1 day to 15 days ) made in the money market.The loans are repayable at the insistence of either the borrower’s demand or the lender’s demand. These assets are highly liquid as they can be quickly converted into cash at call (i.e. on demand ) or at a short notice.Investments Securities issued by central and state government agencies. Securities issued by PSUs of the Central and the state governments. Commercial papers Mutual funds Shares & stocks. Bonds & debenturesAdvancesThis is the most important item in the bank’s asset column.These include the following:Cash credit : Borrower withdraws funds on collateral security , Credit limit is sanctioned by the bank .Interest is charged on the amount outstanding.Overdraft : It is a short term advance,It is allowed on current accounts. Interest is charged.Demand loans : They are short – term loans.They are to be repaid on demand made by the creditor.Term loans : These loans are generally given for a period exceeding one year.Loans are given against the security of tangible assets.They have a specific schedule of repayment.OTHER ASSETS : These include :Fixed assets.Bank premisesItems in transitfurnitures and fixturesthough they do not earn direct revenue for the bank, they are vital for its day-to-day functioning.LIABILITIESPAID-UP CAPITAL :The bank raise their share capital for commencing their banking business as well as for expansion and modernisation.this is actually the contribution of funds by the share holders.Hence it is listed in the ‘ liabilities’ column of the balance sheet.RESERVES AND SURPLUS :This amount represents the sum of undistributed profit accumulated by the bank over a period of years.According to the Banking Regulation Act 1949, a commercial bank needs to provide for at least 20% of its profit every year to reserves.Reserves are maintained to meet contingenciesSince the reserves actually belong to the shareholders, they are the liabilities of the bank.DEPOSITS :Banks accept various forms of deposits from the people.These deposits are the major source of funds for the bankThe main types of deposits are :Current deposits (refer to notes on Banking function for detailed explanation )Savings deposits Fixed deposits Recurring deposits BORROWINGS :Commercial banks resort to borrowings from other financial institutions including the RBI an other commercial bankThey may be in the form of direct borrowing or re financingIt also comprises of overseas borrowings of Indian banks and borrowings of foreign branches.They are generally utilized to meet working capital needs (medium & long term )OTHER LIABILITIES :These liabilities are incurred by the bank in course of banking operations.They include draftsPay slipsTraveller’s chequesBankers cheques etc.Other liabilities include : interest accrued but not due provision for tax, etc.
Liquidity risk consists of Funding Risk, Time Risk & Call Risk. Funding Risk: It is the need to replace net out flows due to unanticipated withdrawal/non-renewal of deposit. Time Risk: It is the need to compensate for non-receipt of expected inflows of funds, i.e. performing assets turning into non-performing assets. Call risk: It happens on account of crystallisation of contingent liabilities and inability to undertake profitable business opportunities when desired.
Interest rate risk - Risk that arises when the interest income/market value of the bank is sensitive to the interest rate fluctuations.Foreign Exchange/Currency Risk- Risk that arises due to unanticipated changes in exchange rates and becomes relevant due to the presence of multi-currency assets and/or liabilities in the bank's balance-sheet.Liquidity risk - Risk that arises due to the mismatch in the maturity patterns of the assets and liabilities. This mismatch may lead to a situation where the bank is not in a position to impart the required liquidity into its system - surplus/ deficit cash situation. In the case of surplus situation this risk arises due to the interest cost on the ideal funds. Thus idle funds deployed at low rates contribute to negative returns.Credit Risk – This is the risk that an issuer of debt obligor is unable to meet its financial obligation. This is known as default. There is also the case of technical default that used to describe the company that has not honoured its interest payment on loan typically for 3 or more month. But still has not reached stage of bankruptcy. Contingency risk - Risk that arises due to the presence of off-balance sheet items such as guarantees, letters of credit, underwriting commitments etc. The intermediation activity of the banks exposes them to various risks not by chance but by choice.
Gap/Mismatch risk: It arises from holding assets and liabilities and off-balance sheet items with different principal amounts, maturity dates & re-pricing dates thereby creating exposure to unexpected changes in the level of market interest rates. Basis Risk: It is the risk that the Interest rate of different Assets/liabilities and off balance items may change in different magnitude. The degree of basis risk is fairly high in respect of banks that create composite assets out of composite liabilities. Embedded option Risk: Option of pre-payment of loan and Fore- closure of deposits before their stated maturities constitutes embedded option risk. Yield curve risk: Movement in yield curve and the impact of that on portfolio values and income. Reprice risk: When assets are sold before maturities. Reinvestment risk: Uncertainty with regard to interest rate at which the future cash flows could be reinvested.Net interest position risk When banks have more earning assets than paying liabilities, net interest position risk arises in case market interest rates adjust downwards.
It takes into consideration interest rates, earning power and degree of willingness to take on debt. It is also called surplus- management
Both Assets and Liabilities are grouped based on their maturing profiles.For maturity of 1 month, we see that the Asset> liabilities, so in this period we can get more liabilities, but For maturity of say 6 months, liabilities > assets, so here what in future we can do is that use our assets for investment for less than or equal to 6 months to square off the liabilities.
Asset and Liability Management in Indian Banks
ASSET AND LIABILITY MANAGEMENT
IN INDIAN BANKS
ROHAN S DEOPA(2740)
• Asset-Liability basic idea
• Risk & Risk management
• RBI Guidelines
• Narasimham Committee
• Basel Accord
– ALM Info
– ALM Process
• ALM implementation Problem
Components of a Bank Balance Sheet
1. Paid in Capital
2. Reserve & Surplus
5. Other Liabilities
1. Cash & Balances with RBI
2. Money at Call and Short
5. Other Assets
Example of Mismatch
Bank A It takes loan from Giver Ltd. and lends to Receiver Ltd.
It borrows Rs 100 million for 1 yr @ 6.00% p.a. from Giver Ltd. and lends to
Receiver Ltd. for 5 years @ 6.20% p.a.
Apparently the gain is: 20 bps
But A have to borrow again at the end of 1 year to finance the loan which still
has 4 more years to mature.
Interest rate for 4 yrs maturity at the end of 1 yr: 7.00% p.a.
Earning is 6.20% p.a. & Payment is 7.00% p.a.
Market Value method of accounting
Asset = 100*(1.06) ^4 = 126.247 million
Liability = 100*(1.07)^4 = Rs 131.079 million
Loss = Rs 4.832 million
So the root cause of problem – Mismatch between Assets & Liabilities.
NPA(Non Performing Assets)
• A Loan which is an asset for a bank turns into a Non Performing Asset
when the EMI, principal or interest component for the loan is not paid
within 90 days from the due date.
• The assets or loans are classified as:-
• A Loss Asset is considered uncollectible and of such little value for the
bank in retaining the account on its book and ideally, such loans should be
written off. Thus, Loss assets should be written off. If loss assets are
permitted to remain in the books for any reason, 100% of the outstanding
should be provided for.
• Apart from above, there are Guidelines by RBI for provisions under special
• ‘Unsecured exposure’ is defined as an exposure where the realizable value
of the security, as assessed by the bank/approved values/RBI’s inspecting
officers, is not more than 10%, ab-initio, of the outstanding exposure.
• ‘Exposure’ includes all funded and non-funded exposures.
• ‘Security’ are tangible security properly discharged to the bank and do not
include intangible securities like guarantees, etc.
Provisioning Coverage Ratio (PCR)
Provisioning Coverage Ratio (PCR):
• The ratio of provisioning to gross non-performing assets.
• Indicates the extent of funds a bank has kept aside to cover loan losses.
As per RBI guidelines, NPA is defined as under:
• Non -performing asset (NPA) is a loan or an advance where;
• interest and/ or instalment of principal remain overdue for a period of more than
90 days in respect of a term loan,
• the account remains‘ out of order’ in respect of an Overdraft/Cash Credit (OD/CC),
• the bill remains overdue for a period of more than 90 days in the case of bills
purchased and discounted,
• the instalment of principal or interest there on remains overdue for two crop
seasons for short duration crops,
• the instalment of principal or interest there on remains overdue for one crop
season for long duration crops,
• the amount of liquidity facility remains outstanding for more than 90 days, in
respect of a securitisation transaction undertaken in terms of guidelines on
securitization dated February 1, 2006.
• in respect of derivative transactions, the overdue receivables representing positive
mark-to-market value of a derivative contract, if these remain unpaid for a period
of 90 days from the specified due date for payment.
Net NPA = Gross NPA – (Balance in Interest Suspense account +
DICGC/ECGC claims received and held pending adjustment + Part payment
received and kept in suspense account + Total provisions held).
BASEL 2 ACCORD
Elements of Basel 2 rules
Basel II is split into three approaches or pillars :-
Pillar 1 – The Minimum Capital Requirements
(1) Credit risk
The capital requirements are stated under two approaches -
The standardised approach.
The internal ratings-based (IRB) approach. Within IRB there is a foundation
approach and an advanced approach, the latter of which gives banks more
scope to set elements of the capital charges themselves.
An element of Basel II is the capital charge to cover banks operational risk.
There are three different approaches for calculating the operational risk capital
charge. These are:
The basic indicator approach, under which 20% of total capital would be
An internal estimation by a bank of the expected losses due to operational risk
each business line. Operational risk here would be risk of loss as a result of IT
and legal risk and so on.
Total Minimum Capital
The sum of the capital calculation for credit risk exposure, operational risk and the
bank's trading book will be the total minimum capital requirement. This capital
requirement will be expressed as an 8% risk-asset ratio, identical to the rules under
Basel 1 .
PILLAR 2 – Supervisory Approach
In Basel II there is a requirement for a supervision approach to capital
First, banks must have a procedure for calculating their capital requirements in
accordance with their individual risk profile.
PILLAR 3 – DISCLOSURE
Basel II sets out rules on core disclosure that banks are required to meet, and
supervisors must enforce.
The disclosures include :
• Capital – The elements that make up the bank's capital, such as the types of
instruments that make up the Tier 1 and Tier 2 capital.
• Risk exposure - The overall risk exposure of a bank, as measured by credit
risk, market risk, operational risk and so on. Hence, this would include a profile of
the ALM book, including maturity profile of the loan book, interest-rate risk.
From the 1991 India economic crisis to its status of third largest economy in
the world by 2011, India has grown significantly in terms of economic
development. So has its banking sector.
Two such expert Committees were set up under the chairmanship of M
Narasimham they submitted their recommendations in the 1990s in reports
widely known as the M Narasimham Committee-I (1991) report and
the Narasimham Committee- 2 (1998) Report.
During the decades of the 60s and the 70s, India nationalised most of its
banks. This culminated with the balance of payments crisis of the Indian
economy where India had to airlift gold to International Monetary Fund (IMF)
to loan money to meet its financial obligations.
Given that rigidities and weaknesses had made serious inroads into the
Indian banking system by the late 1980s, the Government of India
(GOI), post-crisis, took several steps to remodel the country's financial
In the light of these requirements, two expert Committees were set up
in 1990s under the chairmanship of M Narasimham an ex-RBI (Reserve
Bank of India) governor which are widely credited for spearheading the
financial sector reform in India. The first Narasimham Committee
(Committee on the Financial System–CFS) was appointed by Manmohan
Singh as India's Finance Minister on 14 August 1991,and the second one
(Committee on Banking Sector Reforms) was appointed by P
Chidambaram as Finance Minister in December 1998.
The purpose of the Narasimham-I Committee was to study all aspects
relating to the structure, organisation, functions and procedures of the
financial systems and to recommend improvements in their efficiency
and productivity. The Committee submitted its report to the Finance
Minister in November 1991 which was tabled in Parliament on 17
• Stronger banking system
The Committee recommended for merger of large Indian banks to
make them strong enough for supporting international trade.
It recommended a three tier banking structure in India through
establishment of three large banks with international presence, eight to
ten national banks and a large number of regional and local banks.
It cautioned that large banks should merge only with banks of
equivalent size and not with weaker banks.
• Implementation of Recommendations
Based on the other recommendations of the committee, the concept of
a universal bank was discussed by the RBI and finally ICICI bank became
the first universal bank of India. The RBI published an "Actions Taken on
the Recommendations" report on 31 October 2001 on its own website.
The Narasimham-II Committee was tasked with the progress review of the
implementation of the banking reforms since 1992 with the aim of further
strengthening the financial institutions of India. It focussed on issues like
size of banks and capital adequacy ratio among other things.
• Reform in the role of RBI
Pursuant to the recommendations, the RBI introduced a Liquidity
Adjustment Facility (LAF) operated through repo and reverse repos to set a
corridor for money market interest rates.
As for the second recommendation, the RBI decided to transfer its
respective shareholdings of public banks like State Bank of
India (SBI), National Housing Bank (NHB) and National Bank for Agriculture
and Rural Development (NABARD) to GOI.
In 2007–08, GOI decided to acquire entire stake of RBI in SBI, NHB and
Of these, the terms of sale for SBI were finalised in 2007–08 itself.
There were protests by employee unions of banks in India against the report.
The Union of RBI employees made a strong protest against the Narasimham
• An illustration
A typical bank portfolio has an exposure to retail loans, mortgage loans,
personal/credit card loans, corporate loans, cash credit, working capital demand
loans, corporate bonds and commercial papers. For illustration we have considered
a bank with exposures to these loans segments and applied the current and new
risk weights (under Basel II). Implementation of Basel II is likely to improve the risk
management systems of banks as the banks aim for adequate capitalisation to meet
the underlying credit risks and strengthen the overall financial system of the
country. In India, over the short term, commercial banks may need to augment their
regulatory capitalisation levels in order to comply with Basel II. However, over the
long term, they would derive benefits from improved operational and credit risk
• A bank should clearly articulate a liquidity risk tolerance that is
appropriate for its business strategy and its role in the financial system.
• A bank should actively monitor and control liquidity risk exposures and
funding needs within and across legal entities, business lines and
currencies, taking into account legal, regulatory and operational
limitations to the transferability of liquidity.
• A bank should actively manage its collateral positions, differentiating
between encumbered and unencumbered assets. A bank should monitor
the legal entity and physical location where collateral is held and how it
may be mobilised in a timely manner.
• A bank should publicly disclose information on a regular basis that enables
market participants to make an informed judgment about the soundness
of its liquidity risk management framework and liquidity position.
• Top management/ALCO should continuously review information on bank’s
liquidity developments and report to the BoD on a regular basis.
Different types of Risks faced by a
The various risks faced by a bank are:
• Liquidity risk
• Interest rate risk
• Foreign Exchange/Currency Risk
• Country Risk
• Other Risks
• Liquidity risk - Risk that arises due to the mismatch in the maturity patterns of the
assets and liabilities. This mismatch may lead to a situation where the bank is not
in a position to impart the required liquidity into its system - surplus/ deficit cash
• Interest rate risk - Risk that arises when the interest income/market value of the
bank is sensitive to the interest rate fluctuations.
• Foreign Exchange/Currency Risk - Risk that arises due to unanticipated changes in
exchange rates and becomes relevant due to the presence of multi-currency assets
and/or liabilities in the bank's balance-sheet.
• Country Risk : Risk of investing in a country, dependent on changes in the business
environment that may adversely affect operating profits or the value of assets in a
specific country. For example, financial factors such as currency
controls, devaluation or regulatory changes, or stability factors such as mass
riots, civil war and other potential events contribute to companies' operational
risks. This term is also sometimes referred to as political risk.
• Other Risks like credit risks, contingency risks etc.
Liquidity Risk Management
• Liquidity Management is the ability of bank to ensure that its liabilities are
met as they become due. Effective liquidity risk management helps ensure
a bank’s ability to meet its obligations as they fall due and reduces the
probability of an adverse situation being developed.
• The continuous process of raising new funds or investing surplus funds is
known as liquidity management. If we consider that a gap today is
funded, thus balancing assets and liabilities and squaring-off the book, the
next day a new deficit or surplus is generated that also has to be funded.
• There are regulatory requirements that force a bank to operate certain
limits, and state that short-term assets be in excess of short-run
liabilities, in order to provide a safety net of highly liquid assets.
• Liquidity management is also concerned with funding deficits and
investing surpluses, with managing and growing the balance sheet, and
with ensuring that the bank operates within regulatory and in-house
Country Risk Management
• Country risk refers to the risk of investing in a country, dependent on
changes in the business environment that may adversely affect operating
profits or the value of assets in a specific country.
• Financial factors such as currency controls, devaluation or regulatory
changes, or stability factors such as mass riots, civil war and other
potential events contribute to companies' operational risks. This term is
also sometimes referred to as political risk.
• The banks must have an adequate limit system in place for country risk.
The limits must be regularly reviewed and authorised by the senior
management function designated for that purpose.
• Banks decide for themselves on their own provisioning against future
unexpected losses on the basis of their internal risk models and, of
course, within the scope of the current accounting rules.
• 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 have been setting up overnight limits and selectively undertaking active
day time trading .
• However the risk does not get extinguished, but only gets converted in to
Interest Rate Risks
The various types of interest rate risks are detailed below:
• Gap/Mismatch risk
• Basis Risk
• Embedded option Risk
• Yield curve risk
• Reprice risk
• Reinvestment risk
• Net interest position risk
There are different techniques such as
• Maturity Gap Analysis to measure the interest rate sensitivity
• Duration Gap Analysis
• Maturity Matching
A risk management technique designed to earn an adequate return while
maintaining a comfortable surplus of assets beyond liabilities.
Modern tools to address concern areas
Monitoring of asset-liability portfolio and the tolerance level
Early alerts on ALM position and risk profile
Localization of concern areas
Strategy and direction by asset liability committee (ALCO)
ALM aims at profitability through price matching
Price matching maintains spreads by ensuring that the deployment
of liabilities will be at a rate more than the costs
It ensures liquidity by means of Maturity matching
“Maturity Matching” is done by grouping both assets and liabilities
based on their maturity profiles. It ensures liquidity
The framework of ALM revolves round 3 Pillars. They
2. ALM Information Systems.
3. ALM Process.
• 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.
• The size (number of members) of ALCO would depend on the size of each
institution, business mix and organisational complexity.
• 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
ALM Information Systems
• Responsible to collect information accurately, adequately and
• ALM has to be supported by a management philosophy that clearly
specifies the risk policies and tolerance limits.
• The framework needs to be built on sound methodology with necessary
supporting information system, as the central element of the entire ALM
exercise is the availability of adequate and accurate information with
• Aims at maintaining liquidity by grouping assets/liabilities based on their
maturing profiles. The gap is then assessed to identify future financing
requirements (Rs. Cr.) (Period in months)
Table 1 Table 1 (Rearranged)
Liabilities sMaturing in Assets Maturing in Liabilities Assets Gap Cumul. Gap
10 1 15 1 10 15 -5 -5
5 3 10 3 5 10 -5 -10
8 6 5 6 8 5 3 -7
4 12 10 12 4 10 -6 -13
45 24 30 24 45 30 15 2
20 36 10 36 20 10 10 12
8 >36 20 >36 8 20 -12 0
100 100 100 100
ALM Process Continues..
Duration Gap Analysis:
To measure interest rate sensitivity of capital
Gap Ratio= (interest rate sensitive Assets)/(interest rate sensitive Liabilities)
» Gap Ratio > 1 rise in interest increases NPV
» Gap Ratio<1 rise in interest decreases NPV
Duration Gap = Duration of Assets – w(Duration of liabilities)
W= Percentage of Assets funded by liabilities
It measures the effects of the change in the net worth of bank
Higher Duration gap = Higher interest risk exposure
ALM Implementations and problem in
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.
• Understanding of complexities
Many people in a bank need to understand risk measurements and risk
Measurement of risk is a fairly simple phenomenon and does go on
• Organisation and culture
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
• Unrealistic goals
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
• Interest rate risk and liquidity risks are significant risks in a bank’s balance
sheet, which should be regularly monitored and managed. These two aspects
should be a key input in business planning process of a bank.
• Banks should make sure that increased balance sheet size should not result in
excessive asset liability mismatch resulting in volatility in earnings.
• There should be proper limit structures, which should be monitored by Asset
Liability Management Committee (ALCO) on a regular basis. Do involve all ALCO
members in decisions. Some functional heads may not be interested. It is best to
have someone as a salesman for ALCO to sell ideas, how important these ideas are
to implement central systems for better benefits for bank.
• The effectiveness of ALM system should be improved with a good Fund Transfer
• Amalesh Banerjee, S.K. Singh. Banking & Financial Sector Reforms in India-Deep & Deep
• Current ratings provided by ICRA. http://www.icra.in/CurrentRating.aspx
• Fabozzi, FJ. , & Konishi , A. (1995). Asset-liability management. New Delhi: S Chand & Co.
• Government of India (1998): Report of the Committee on Banking Sector Reforms
(Chairman: M Narasimham).
• Moorad Chudhry (2008).The principles of banking-Wiley Finance. Chapter 2 Bank Regulatory
• M. Y. Khan (2010).Indian Financial System. Page
• Reserve Bank of India guideline on ALM.