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ALM- an introduction


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This is a simple introduction to the vast subject of Asset Liability Management in Banks

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ALM- an introduction

  1. 1. RISK IN BALANCE SHEET OF A BANK- INTRODUCTION TO ALM ग ाँव बढ़े तो देश बढ़े /nabardonline Taking Rural India >> Forward K. R. Chandra
  2. 2. WHAT IS ALM ALM is the process involving decision making about the composition of assets and liabilities including off balance sheet items of the bank and conducting the risk 2
  3. 3. WHAT IS ALM- CONTD…. Concerned with strategic Balance Sheet management Match between assets and liabilities in BS Risks stem from mismatch between A&L – credit, liquidity, interest, currency ALM is not to avoid risk but to manage risk, sustaining profitability •Periodic monitoring of risk exposures involving collecting and analyzing information •Ability to anticipate, forecast and act so as to structure bank’s business to profit •Altering A & L portfolio in a dynamic way to manage risks •Involves judgment and decision making 3ग ाँव बढ़े तो देश बढ़े /nabardonline Taking Rural
  4. 4. WHY ALM Globalization of financial markets. Deregulation of Interest Rates. Multi-currency Balance Sheet. Integration of Markets – Money Market, Forex Market, Government Securities Market. Narrowing NII / NIM 4
  5. 5. COMPONENTS OF A BANK BALANCE SHEET 5 Liabilities Assets 1. Capital 2. Reserve & Surplus 3. Deposits 4. Borrowings 5. Other Liabilities & provisions 1. Cash & Balances with RBI 2. Bal. With Banks & Money at Call and Short Notices 3. Investments 4. Advances 5. Fixed Assets 6. Other Assets
  6. 6. BOOK VALUE VRS. MARKET VALUE ACCOUNTING A bank borrows Rs.10 Crore at 3.00% for a year and lends the same money at 3.20% for 5 years. At the end of a year, an applicable 4-year interest rate is 6.00% Book(Accrual) Value Accounting: Asset 10 cr.X 1.032= Rs.10.32 crore Liability 10 cr.X1.03=Rs.10.30 crore. Hence profit- 2 lakh Market Value Accounting : Asset 10 cr.X (1.032)5/(1.06)4 = Rs.9.27cr Liability 10 cr.X1.03=Rs.10.30 crore. Hence loss- Rs. 1.03 cr. 6
  7. 7. LET US READ MARKET’S MIND Two groups of people in the financial market – lenders & borrowers Borrowers prefer longer time frame Lenders prefer shorter timer frame (liquidity preference) Banks assume the role of a intermediary between lenders & Borrowers (accepting deposits & issuing loans) Hence bankers’ liabilities are short term in nature & assets are long term in nature Result - LT interest rates exceed ST interest rates Incentive for Banks for performing the intermediation role = Interest Spread 8ग ाँव बढ़े तो देश बढ़े /nabardonline Taking Rural
  8. 8. INTERMEDIATION FUNCTIONS OF BANKS Banks perform various types of intermediation functions : 1.Denomination Intermediation - Banks pool funds from small depositors - Issue larger loans to big customers / industries – This leads to Liquidity Risk 2.Default Risk Intermediation : - Banks mobilise deposits by issuing safe and liquid securities (FDRs) - Providing loans to risky borrowers by taking relatively less safe and less liquid securities (Guarantee / Mortgage). - This leads to credit risk. 9ग ाँव बढ़े तो देश बढ़े /nabardonline Taking Rural
  9. 9. INTERMEDIATION FUNCTIONS OF BANKS-CONTD.. 3.Maturity Intermediation : Accepting deposits from savers for a comparatively shorter period of time Issuing long term loans to borrowers Results in Interest Rate Risk ST funds invested in LT loans / LT funds invested in ST loans 10ग ाँव बढ़े तो देश बढ़े /nabardonline Taking Rural
  10. 10. WHAT IS RISK Deviations from planned Uncertainty resulting in adverse outcome Financial risk: uncertainty resulting in adverse variation of profitability or outright loss Uncertainty impact the variation in net cash flow favorably or unfavorably Lower risk implies lower variability with lower upside or downside potential 11ग ाँव बढ़े तो देश बढ़े /nabardonline Taking Rural
  11. 11. Survival of organization in severe adverse conditions Cash flows effected resulting in high loss to wipe out the capital/ bankruptcy Can be avoided if, loss potential can be controlled Loss potential is correlated to uncertainties of business ie risk in the business Develop method to measure risk, awareness to risk & potential loss from risk. 12ग ाँव बढ़े तो देश बढ़े /nabardonline Taking Rural Why Manage risk?
  12. 12. To determine adequate capital for continuance or limit its risk exposure to the extent of capital available. Loss out of business has to be accounted for by factoring it in to pricing. Over estimation or underestimation of risk may result into over pricing or underpricing impacting the business. Controlling the level of risk to the organisations capacity to bear the risk. Highly skilled job and needs a special set up. 13ग ाँव बढ़े तो देश बढ़े /nabardonline Taking Rural Why Manage risk?- contd….
  13. 13. Liquidity Risk: LT asset by ST Liabilities Funding risk: unanticipated withdrawal/ non renewal of deposits Time risk: non receipt of expected inflow Call risk: Crystalisation of contingent liabilities Banks face 4 Basic financial risk Credit risk, Interest rate risk, Foreign exchange risk and Liquidity risk 14ग ाँव बढ़े तो देश बढ़े /nabardonline Taking Rural Different risks???
  14. 14. Credit Risk – loss arising on account of default in repayment Interest rate Risk – Risk of loss arising on account of changes in the market interest rates Liquidity Risk – Inability to generate cash to meet the requirements, mismatch in maturity pattern of assets and liabilities Capital Risk – Inability to maintain adequate capital on continuous basis to meet risk, statutory requirement, business needs etc. Market Risk – Adverse impact on financial condition due to adverse movement in market prices Exposure Risk – Risk due to large exposure to single party/sector Operational Risk – Risk arising on account of failed internal control, processes, systems etc. 15ग ाँव बढ़े तो देश बढ़े /nabardonline Taking Rural Different risk in Banks
  15. 15. RISK MANAGEMENT IN BANKS- CASE EXERCISE- 1 Assets (million Rs.) Liabilities (million Rs.) 100 (5 years fixed rate 90 (30 day deposits @ 4 %) loan @ 8 %) Equity 10 Total 100 100 NII = 8.00-3.6 = 4.4 million Rs. NIM = 4.4/100 = 4.4 %
  16. 16. RISK MANAGEMENT IN BANKS- CASE EXERCISE- 2 If market rate of interest increases by 200 basis point from 4 % to 6 %, what would be its impact on NII and NIM? The cost of the short term borrowing will increase, but the interest income from long term fixed rate loan will remain unchanged.
  17. 17. RISK MANAGEMENT IN BANKS- CASE EXERCISE- 3 Interest expenses will increase from 3.6 million to 5.4 million Interest income is not effected because all the loans are at long term fixed rate. In this case, NII falls to 2.6 million (8.00-5.4 = 2.6) and, NIM = 2.6/100 = 2.6 per cent
  18. 18. RISK MANAGEMENT IN BANKS- CASE EXERCISE- 4 If the bank had made the loans at a variable (floating) rate, then with increase in interest rate by 200 basis point, what would be the impact on NII and NIM? NII = 10.00-5.4 = 4.6 NIM = 4.6/100 = 4.6 percent
  19. 19. RISK MANAGEMENT IN BANKS Banks make loans and raise funds with many different maturities and interest rates Therefore NII and NIM depend on Interest rate earned on assets and paid for funds The amount and composition of various earning assets and liabilities
  20. 20. By attempting to match the assets and liabilities  in terms of their maturities and interest rate sensitivities  To contain the risk arising from such mismatches within the desired level By controlling volatility of  Net Interest Income  Net Income,  Net Interest Margin  to have an acceptable balance between profitability, growth and risk  By controlling liquidity risk 21ग ाँव बढ़े तो देश बढ़े /nabardonline Taking Rural How to Manage??..
  21. 21. Two approaches: - on-balance sheet adjuste sheet adjustments On Balance sheet Adjustments - involve changing the portfolio of assets and liabilities in order to change the manner in which the profitability of the bank or amount of its assets and liabilities changes as interest rate change. - adjusting the maturity, re-pricing and payment schedule of assets and liabilities APPROACHES TO MANAGE INTEREST RATE RISK Two approaches: - on-balance sheet adjustments - off-balance sheet adjustments On Balance sheet Adjustments - involve changing the portfolio of assets and liabilities in order to change the manner in which the profitability of the bank or amount of its assets and liabilities changes as interest rate change. - adjusting the maturity, re-pricing and payment schedule of assets and liabilities 22ग ाँव बढ़े तो देश बढ़े /nabardonline Taking Rural
  22. 22. ASSETS AND LIABILITY MANAGEMENT The process of making such decisions about the composition of assets and liabilities and the risk assessment is known as Asset/Liability Management (ALM). The decisions are usually made by asset/liability management committee (ALCO).
  23. 23. ASSETS AND LIABILITY MANAGEMENT ALCO goal is to manage the sources and use of funds with respect to interest rate and liquidity. ALM is generally viewed as short run in nature, forcing on the day to day and week to week balance sheet management.
  24. 24. The process of making such decisions about the composition of assets and liabilities and the risk assessment is known as Asset/Liability Management (ALM). The decisions are usually made by asset/liability management committee (ALCO). HOW IT ALL STARTED.. Initially pioneered by Anglo-Saxon financial institutions during the 1970s as interest rates became increasingly volatile ALM was started as practice of managing risks that arise due to mismatches between the assets and liabilities The process is at the crossroads between risk management and strategic planning. It is not just about offering solutions to mitigate or hedge the risks arising from the interaction of assets and liabilities but is focused on a long-term perspective The traditional ALM programs focus on interest rate risk and liquidity risk because they represent the most prominent risks affecting the organization balance-sheet Capital management was added later It is the process of making decisions about the composition of assets and liabilities and the risk assessment These decisions are usually made by asset/liability management committee (ALCO). 25 ग ाँव बढ़े तो देश बढ़े /nabardonline Taking Rural
  25. 25. How to go about? How to gear ourselves up? Let us try See this video 26ग ाँव बढ़े तो देश बढ़े /nabardonline Taking Rural
  26. 26. ASSET LIABILITY MANAGEMENT Various risks affecting banks / FIs Credit, Market, Operational Deregulation & competition Need to manage risk to protect NIM Need for proper risk mgt policy Liquidity planning, interest rate risk management ALM guidelines issued for banks in Feb 1999 and for FIs in Dec 1999
  27. 27. CONCEPT OF ALM ALM is concerned with strategic management of Balance Sheet by giving due weightage to market risks viz. Liquidity Risk, Interest Rate Risk & Currency Risk. ALM function involves planning, directing, controlling the flow, level, mix, cost and yield of funds of the bank ALM builds up Assets and Liabilities of the bank based on the concept of Net Interest Income (NII) or Net Interest Margin (NIM).
  28. 28. WHAT IS ALM ALM is concerned with strategic Balance Sheet management involving all market risks It involves in managing both sides of balance sheet to minimise market risk
  29. 29. ALM OBJECTIVES Liquidity Risk Management. Interest Rate Risk Management. Currency Risks Management. Profit Planning and Growth Projection.
  30. 30. LIQUIDITY RISK What is liquidity risk?  Liquidity risk refers to the risk that the institution might not be able to generate sufficient cash flow to meet its financial obligations EFFECTS OF LIQUIDITY CRUNCH Risk to bank’s earnings Reputational risk Contagion effect Liquidity crisis can lead to runs on institutions  Bank / FI failures affect economy
  31. 31. LIQUIDITY RISK Factors affecting liquidity risk Over extension of credit High level of NPAs Poor asset quality Mismanagement Non recognition of embedded option risk Reliance on a few wholesale depositors Large undrawn loan commitments Lack of appropriate liquidity policy & contingent plan
  32. 32. LIQUIDITY RISK Tackling the liquidity problem  A sound liquidity policy  Funding strategies  Contingency funding strategies  Liquidity planning under alternate scenarios  Measurement of mismatches through gap statements
  33. 33. LIQUIDITY RISK METHODOLOGIES FOR MEASUREMENT  Liquidity index  Peer group comparison  Gap between sources and uses  Maturity ladder construction
  34. 34. LIQUIDITY RISK RBI GUIDELINES  Structural liquidity statement  Dynamic liquidity statement  Board / ALCO  ALM Information System  ALM organisation  ALM process (Risk Mgt process)  Mismatch limits in the gap statement  Assumptions / Behavioural study
  35. 35. MATURITY PROFILE-LIQUIDITY Outflows  Capital, Reserves & Surplus  Deposits  Borrowings and bonds  Other liabilities
  36. 36. MATURITY PROFILE-LIQUIDITY Inflows  Cash  Balance with RBI  Balance with other banks  Investments  Advances
  37. 37. IRR - RELEVANCE IN INDIA Deregulation of interest rates brought:  Volatility in rates - call, PLR, Govt. securities Yield Curve  Competition - free pricing of assets and liabilities  Pressure on NII / NIM, MVE
  38. 38. RSA, RSL RSA (Rate Sensitive Assets) – Assets whose value is dependent on current interest rate RSL (Rate Sensitive Liabilities) – Liabilities whose value is dependent on current interest rate
  39. 39. GAP/MISMATCH RISK It arises on account of holding rate sensitive assets and liabilities with different principal amounts, maturity/repricing rates 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
  40. 40. IMPACT ON NII Gap Interest rate Change Impact on NII Positive Increases Positive Positive Decreases Negative Negative Increases Negative Negative Decreases Positive
  41. 41. ASSET-LIABILITY MANAGEMENT COMMITTEE (ALCO) This committee operates typically just below the board. In smaller banks the responsibility is vested with the board of management.
  42. 42. FUNCTIONS OF ALCO Implementation of ALM System - Monitor the risk levels of the Bank. - Articulate the Interest Rate Position & fix interest rate on Deposits & Advances. - Fix differential rate of interest rate on Bulk Deposits. - Facilitating and coordinating to put in place the ALM System in the Bank.
  43. 43. TOOLS FOR ALM SYSTEM Gap Analysis Modified Gap Analysis Duration Gap Analysis Value at Risk (VaR) Simulation
  44. 44. LIQUIDITY RISKS Broadly of three types: Funding Risk: Due to withdrawal/non-renewal of deposits Time Risk: Non-receipt of inflows on account of assets(loan installments) Call Risk: contingent liabilities & new demand for loans Dynamic liquidity is done to measure the liquidity risks
  45. 45. STATEMENT OF STRUCTURAL LIQUIDITY Placed all cash inflows and outflows in the maturity ladder as per residual maturity Maturing Liability: cash outflow Maturing Assets : Cash Inflow Classified in to 8 time buckets Mismatches in the first two buckets not to exceed 20% of outflows Banks can fix higher tolerance level for other maturity buckets.
  46. 46. ADDRESSING TO MISMATCHES Mismatches can be positive or negative Positive Mismatch: M.A.>M.L. and vice-versa for Negative Mismatch In case of +ve mismatch, excess liquidity can be deployed in money market instruments, creating new assets & investment swaps etc. For –ve mismatch,it can be financed from market borrowings(call/Term),Bills rediscounting,repos & deployment of foreign currency converted into rupee.
  47. 47. DYNAMIC LIQUIDITY Prepared every fortnight for ALCO Projection is given for the next three months Tools for assessing the day to day liquidity needs of the bank
  48. 48. STATEMENT OF INTEREST RATE SENSITIVITY Generated by grouping RSA,RSL & OFF-Balance sheet items in to various (8)time buckets. Positive gap : Beneficial in case of rising interest rate Negative gap: Beneficial in case of declining interest rate
  50. 50. SUCCESS OF ALM IN BANKS : PRE - CONDITIONS 1. Awareness for ALM in the Bank staff at all levels–supportive Management & dedicated Teams. 2. Method of reporting data from Branches/ other Departments. (Strong MIS). 3. Computerization - Full computerization, networking. 4. Insight into the banking operations, economic forecasting, computerization, investment, credit. 5. Linking up ALM to future Risk Management Strategies.
  51. 51. THANK YOU 3ग ाँव बढ़े तो देश बढ़े /nabardonline Taking Rural