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Asset and Liability Management in Indian Banks

Asset and Liability Management in Indian Banks.

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Asset and Liability Management in Indian Banks

  2. 2. Agenda • Asset-Liability basic idea • Risk & Risk management • NPA • RBI Guidelines • Narasimham Committee • Basel Accord • ALM – ALCO – ALM Info – ALM Process • ALM implementation Problem • Suggestion
  3. 3. Components of a Bank Balance Sheet Liabilities 1. Paid in Capital 2. Reserve & Surplus 3. Deposits 4. Borrowings 5. Other Liabilities Asset 1. Cash & Balances with RBI 2. Money at Call and Short Notices 3. Investments 4. Advances 5. Other Assets
  4. 4. 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. Here 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.
  5. 5. 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:- Standard Assets Sub-standard Assets Doubtful Assets Loss Assets
  6. 6. Asset Classification
  7. 7. NPA- Continues.. • 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 circumstances. • ‘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.
  8. 8. 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.
  9. 9. NPA(RBI Guidelines) 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.
  10. 10. Net NPA 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).
  11. 11. Net NPA of Indian Banks
  12. 12. 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.
  13. 13.  Operational Risk 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 allocated.  An internal estimation by a bank of the expected losses due to operational risk for each business line. Operational risk here would be risk of loss as a result of IT Failures 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 .
  14. 14. PILLAR 2 – Supervisory Approach  In Basel II there is a requirement for a supervision approach to capital allocation.  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 which 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.
  15. 15. Narasimham Committee  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. • Background  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.
  16. 16.  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 system.  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 December 1991.
  17. 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.
  18. 18.  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 NABARD. Of these, the terms of sale for SBI were finalised in 2007–08 itself.
  19. 19. • Criticism  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 2 report. • 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 management practice.
  20. 20. RBI Guidelines • 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.
  21. 21. Different types of Risks faced by a bank: The various risks faced by a bank are: • Liquidity risk • Interest rate risk • Foreign Exchange/Currency Risk • Country Risk • Other Risks
  22. 22. Continued.. • 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. • 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.
  23. 23. Risk Management Various Risk management techniques: • Liquidity Risk Management • Interest Rate Risk Management • Currency Risk Management • Country Risk Management
  24. 24. 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 limits.
  25. 25. 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.
  26. 26. Currency Risks • 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 credit risk.
  27. 27. 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
  28. 28. ALM Defination: A risk management technique designed to earn an adequate return while maintaining a comfortable surplus of assets beyond liabilities. Objectives:  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)
  29. 29. ALM Strategy  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
  30. 30. ALM Frameworks The framework of ALM revolves round 3 Pillars. They are – 1. ALCO. 2. ALM Information Systems. 3. ALM Process.
  31. 31. ALCO • 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
  32. 32. ALM Information Systems • Responsible to collect information accurately, adequately and expeditiously. • 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 expedience.
  33. 33. ALM Process Maturity Matching: • 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
  34. 34. 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
  35. 35. ALM Implementations and problem in bank • 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. • 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.
  36. 36. • 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 completely independently. • 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 are not.
  37. 37. Suggestions • 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 Pricing system.
  38. 38. References • Amalesh Banerjee, S.K. Singh. Banking & Financial Sector Reforms in India-Deep & Deep • Current ratings provided by ICRA. • 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 Capital-page 84-89 • M. Y. Khan (2010).Indian Financial System. Page • Reserve Bank of India guideline on ALM.