Alm in banks by Prabin kumar Parida, MFC, Utkal University


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Alm in banks by Prabin kumar Parida, MFC, Utkal University

  1. 1. Page | 1 CHAPTER-1: INTRODUCTION
  2. 2. Page | 2 1.1 Introduction Assets and Liabilities Management (ALM) is a dynamic process of planning, organizing, coordinating and controlling the assets and liabilities – their mixes, volumes, maturities, yields and costs in order to achieve a specified Net Interest Income (NII). The NII is the difference between interest income and interest expenses and the basic source of banks profitability. The easing of controls on interest rates has led to higher interest rate volatility in India. Hence, there is a need to measure and monitor the interest rate exposure of Indian banks. Banks are always aiming at maximizing profitability at the same time trying to ensure sufficient liquidity to repose confidence in the minds of the depositors on their ability in servicing the deposits by making timely payment of interest/returning them on due dates and meeting all other liability commitments as agreed upon. To achieve these objectives, it is essential that banks have to monitor, maintain and manage their assets and liabilities portfolios in a systematic manner taking into account the various risks involved in these areas. This concept has gained importance in Indian conditions in the wake of the ongoing financial sector reforms, particularly reforms relating to interest rate deregulation. The technique of managing both assets and liabilities together has come into being as a strategic response of banks to inflationary pressure, volatility in interest rates and severe recessionary trends which marked the global economy in the seventies and eighties. The commercial banking sector plays an important role in mobilization of deposits and disbursement of credit to various sectors of the economy. A sound and efficient banking system is essential for maintaining financial stability. The financial strength of individual banks, which are major participants in the financial system, is the first line of defence against financial risks. The banking industry in India is undergoing transformation since the beginning of liberalization. Banks in India are venturing into non-traditional areas and generating income through diversified activities other than the core banking activities. There have been new banks, new instruments, new windows, new opportunities and, along with all this, new challenges. While deregulation has opened up new vistas for banks to augment revenues, it has entailed greater competition, reduced margins and consequently greater risks. Banks enter into off balance sheet (OBS) transactions for extending non- fund based facilities to their clients, balance sheet risk management and generating profits through leveraged positions. OBS exposures of banks, especially public sector banks have witnessed a phenomenal spurt in recent years.
  3. 3. Page | 3 The start of the reforms in Banking Sector brought out number of skeletons and exposed the darker side of the banking industry. Some of these were:- (a) Mind blowing size of the Non Performing Assets; (b) Losses in number of banks (c) Overstaffing in most of the public sector banks (d) Scant respect for norms for income recognition and international standard accounting practices. 1.2 Rationale of the Study:- This is the era of reforms in the Economy. Indian banking sector is facing a lot of challenges now-a-days regarding management of Assets and Liability. In general the deposits which are the liability for the banks are for short-term periods and the loans which are assets for the banks are for the long-term periods. So it is very difficult for the banks to arrange the funds to meet the demand for both the sides. In the other hand deposits are mainly for on-demand payments. So the assets & Liabilities need to be managed very properly in order to align the short-term & Long-term funds accordingly. The interest rates also fluctuate to attract deposits and as a result it also results in a higher lending rate which creates a less demand for loans. It is observed that the NPA level of banks is getting increased day by day which is also caused by Asset-Liability mismatch up to some extent. Sometimes banks are failing in timely payment to customers who opt for heavy amount withdraws. The banks are facing a lot of challenges due to heavy risks they are taking. Though a lots of studies have been conducted on this topic, yet the banks suffering from this problem. Still there is a scope for improvement in the management of asset and liabilities of the banks. That‘s why the subject has been taken into consideration so that some new findings can be suggested which will help the bankers.1.3 Review of Literature:- 1.4Objectives:- To study the concept of Asset & Liability Management To study the various risk measures undertaken through ALM. To analyse the Interest Rate Risk Management system in SBI Bank.
  4. 4. Page | 4 1.5 Research Methodology:- Methodology is the back bone of the project work. It involves the ways and means by which the researcher selects his sample, sample size, Methods of data collection. Scope of the Study: The scope of my study pertains to all the data, resources, information and knowledge collected from the websites of SBI,RBI & other websites, Direct interaction with the experienced people etc. Although the scope is not so vast, still it contains as many information as was possible on my part to collect within the limited time-frame. Sources of Data: The study is mainly based on secondary data. The secondary data were collected from the annual reports of SBI Bank, circulars of the SBI Bank, reading material on ALM, RBI Reports, websites and various journals. Time Frame: 3 years data has been taken into consideration. Tools & Techniques used: Statistical tools like Addition, Average etc are used to analyse the data. Gap Analysis Technique (prescribed by RBI) has been used for measuring the interest rate risk. This is an analytical research study. It selected SBI Bank, one of the largest public sector banks in India. The bank is listed in BSE Sensex and NSE Nifty.
  5. 5. Page | 5 1.7 Limitations:-  This subject is based on past data of State Bank of India.  The study is mainly based on secondary data.  Some results are approximated, as no accurate data is Available.  Time was a limiting factor in this study  The area of study considered was quite a vast field of study and lack of sufficient time was also a constraint.  Due to lack of time and some other reasons, the primary data couldn‘t be collected which could give a better result of the study. 1.6 Study Design:-  Chapter-1: Introduction  Chapter-2: Bank Profile  Chapter-3: Overall ALM  Chapter-4: Case Study  Chapter-5: Findings, Suggestions and Conclusion
  6. 6. Page | 6 CHAPTER-2: BANK PROFILE
  7. 7. Page | 7 2.1 State Bank of India: An overview:- State Bank of India (SBI) is a multinational banking and financial services company based in India. It is a government-owned corporation with its headquarters in Mumbai, Maharashtra. As of December 2013, it had assets of US$388 billion and 17,000 branches, including 190 foreign offices, making it the largest banking and financial services company in India by assets. State Bank of India is one of the Big Four banks of India, along with ICICI Bank, Punjab National Bank and Bank of Baroda. The bank traces its ancestry to British India, through the Imperial Bank of India, to the founding in 1806 of the Bank of Calcutta, making it the oldest commercial bank in the Indian Subcontinent. Bank of Madras merged into the other two presidency banks—Bank of Calcutta and Bank of Bombay—to form the Imperial Bank of India, which in turn became the State Bank of India. Government of India owned the Imperial Bank of India in 1955, with Reserve Bank of India taking a 60% stake, and renamed it the State Bank of India. In 2008, the government took over the stake held by the Reserve Bank of India. SBI is a regional banking behemoth and has 20% market share in deposits and loans among Indian commercial banks. SBI provides a range of banking products through its network of branches in India and overseas, including products aimed at non-resident Indians (NRIs). SBI has 14 regional hubs and 57 Zonal Offices that are located at important cities throughout India. 2.2 Domestic presence:- SBI had 14,816 branches in India, as on 31 March 2013, of which 9,851 (66%) were in Rural and Semi-urban areas. In the financial year 2012-13, its revenue was INR 200,560 Crores (US$ 36.9
  8. 8. Page | 8 billion), out of which domestic operations contributed to 95.35% of revenue. Similarly, domestic operations contributed to 88.37% of total profits for the same financial year. 2.3 International presence:- The Israeli branch of the State Bank of India located in Ramat Gan. As of 28 June 2013, the bank had 180 overseas offices spread over 34 countries. It has branches of the parent in Moscow, Colombo, Dhaka, Frankfurt, Hong Kong, Tehran, Johannesburg, London, Los Angeles, Male in the Maldives, Muscat, Dubai, New York, Osaka, Sydney, and Tokyo. It has offshore banking units in the Bahamas, Bahrain, and Singapore, and representative offices in Bhutan and Cape Town. It also has an ADB in Boston, USA. The Canadian subsidiary, State Bank of India (Canada) also dates to 1982. It has seven branches, four in the Toronto area and three in the Vancouver area. SBI operates several foreign subsidiaries or affiliates. In 1990, it established an offshore bank: State Bank of India (Mauritius). SBI (Mauritius) has 15 branches in major cities/towns of the country including Rodrigues. State Bank of India (S.B.I.) has Branch at Tsim Sha Tsui, Hong Kong In 1982, the bank established a subsidiary, State Bank of India (California), which now has ten branches – nine branches in the state of California and one in Washington, D.C. The 10th branch was opened in Fremont, California on 28 March 2011. The other eight branches in California are located in Los Angeles, Artesia, San Jose, Canoga Park, Fresno, San Diego, Tustin and Bakersfield. In Nigeria, SBI operates as INMB Bank. This bank began in 1981 as the Indo-Nigerian Merchant Bank and received permission in 2002 to commence retail banking. It now has five branches in Nigeria. In Nepal, SBI owns 55% of Nepal SBI Bank, which has branches throughout the country. In Moscow, SBI owns 60% of Commercial Bank of India, with Canara Bank owning the rest. In Indonesia, it owns 76% of PT Bank Indo Monex. The State Bank of India already has a branch in Shanghai and plans to open one in Tianjin. In Kenya, State Bank of India owns 76% of Giro Commercial Bank, which it acquired for US$8 million in October 2005.
  9. 9. Page | 9 2.4 Associate banks:- SBI main branch at Mumbai lit up Main Branch of SBI in Mumbai. SBI has five associate banks; all use the State Bank of India logo, which is a blue circle, and all use the "State Bank of" name, followed by the regional headquarters' name: State Bank of Bikaner & Jaipur State Bank of Hyderabad State Bank of Mysore State Bank of Patiala State Bank of Travancore 2.5 Non-banking subsidiaries Apart from its five associate banks, SBI also has the following non-banking subsidiaries: SBI Capital Markets Ltd SBI Funds Management Pvt Ltd SBI Factors & Commercial Services Pvt Ltd SBI Cards & Payments Services Pvt. Ltd. (SBICPSL) SBI DFHI Ltd SBI Life Insurance Company Limited SBI General Insurance In March 2001, SBI (with 74% of the total capital), joined with BNP Paribas (with 26% of the remaining capital), to form a joint venture life insurance company named SBI Life Insurance company Ltd. In 2004, SBI DFHI (Discount and Finance House of India) was founded with its headquarters in Mumbai.
  10. 10. Page | 10 2.6 Logo and slogan:- The logo of the State Bank of India is a blue circle with a small cut in the bottom that depicts perfection and the small man the common man - being the centre of the bank's business. The logo came from National Institute of Design(NID), Ahmedabad and it was inspired by Kankaria Lake, Ahmedabad. Slogans: "PURE BANKING, NOTHING ELSE", "WITH YOU - ALL THE WAY", "A BANK OF THE COMMON MAN", "THE BANKER TO EVERY INDIAN", "THE NATION BANKS ON US" 2.7 Recent awards and recognitions:- SBI was ranked as the top bank in India based on tier 1 capital by The Banker magazine in a 2014 ranking. SBI was ranked 298th in the Fortune Global 500 rankings of the world's biggest corporations for the year 2012. SBI won "Best Public Sector Bank" award in the D&B India's study on 'India's Top Banks 2013'. State Bank of India won three IDRBT Banking Technology Excellence Awards 2013 for ―Electronic Payment Systems‖, ―Best use of technology for Financial Inclusion‖, and ―Customer Management & Business Intelligence‖ in the large bank category. SBI won National Award for its performance in the implementation of Prime Minister‘s Employment Generation Programme (PMEGP) scheme for the year 2012. Best Online Banking Award, Best Customer Initiative Award & Best Risk Management Award (Runner Up) by IBA Banking Technology Awards 2010 SKOCH Award 2010 for Virtual corporation Category for its e-payment solution SBI was the only bank featured in the "top 10 brands of India" list in an annual survey conducted by Brand Finance and The Economic Times in 2010. The Bank of the year 2009, India (won the second year in a row) by The Banker Magazine Best Bank – Large and Most Socially Responsible Bank by the Business Bank Awards 2009 Best Bank 2009 by Business India
  11. 11. Page | 11 The Most Trusted Brand 2009 by The Economic Times. SBI was named the 29th most reputed company in the world according to Forbes 2009 rankings Most Preferred Bank & Most preferred Home loan provider by CNBC Visionaries of Financial Inclusion By FINO Technology Bank of the Year by IBA Banking Technology Awards SBI was 11th most trusted brand in India as per the Brand Trust Report 2010. 2.8 Major competitors:- Some of the major competitors for SBI in the banking sector are Axis Bank, ICICI Bank, HDFC Bank, Punjab National Bank, Bank of Baroda, Canara Bank and Bank of India. However in terms of average market share, SBI is by far the largest player in the market. 2.9 VISION:-  My SBI.  My Customer first.  My SBI: First in customer satisfaction 2.10 MISSION:-  We will be prompt, polite and proactive with our customers.  We will speak the language of young India.  We will create products and services that help our customers achieve their goals.  We will go beyond the call of duty to make our customers feel valued.  We will be of service even in the remotest part of our country.  We will offer excellence in services to those abroad as much as we do to those in India.  We will imbibe state of the art technology to drive excellence.
  12. 12. Page | 12 2.11 VALUES:-  We will always be honest, transparent and ethical.  We will respect our customers and fellow associates.  We will be knowledge driven.  We will learn and we will share our learning.  We will never take the easy way out.  We will do everything we can to contribute to the community we work in.  We will nurture pride in India 2.12 Management Team:- Sr.No. Name Designation Under Section of SBI Act 1955 1 Smt. Arundhati Bhattacharya Chairman 19(a) 2 Shri Hemant G. Contractor Managing Director 19 (b) 3 Shri A. Krishna Kumar Managing Director 19 (b) 4 Shri S.Vishvanathan Managing Director 19 (b) 5 Shri P. Pradeep Kumar Managing Director 19(b) 6 Shri S. Venkatachalam Director 19 (c) 7 Shri D. Sundaram Director 19 (c) 8 Shri Parthasarathy Iyengar Director 19 (c) 9 Shri Thomas Mathew Director 19 (c) 10 Shri Jyoti Bhushan Mohapatra Workmen Employee Director 19 (ca) 11 Shri S.K. Mukherjee Officer Employee Director 19 (cb) 12 Dr. Rajiv Kumar Director 19 (d) 13 Shri Deepak I. Amin Director 19 (d) 14 Shri Harichandra Bahadur Singh Director 19 (d) 15 Shri Tribhuwan Nath Chaturvedi Director 19(d) 16 Shri Gurdial Singh Sandhu Director 19 (e) 17 Dr. Urjit R. Patel Director 19 (f)
  13. 13. Page | 13 CHAPTER-3: OVERALL ALM
  14. 14. Page | 14 3.1 CONCEPT OF ALM:- ALM is the practice of managing a business so that decisions and actions taken with respect to assets and liabilities are coordinated. ALM can be defined as the ongoing process of formulating, implementing, monitoring and revising strategies related to assets and liabilities to achieve an organization's financial objectives, given the organization's risk tolerances and other constraints. ALM is relevant to, and critical for, the sound management of the finances of any organization that invests to meet its future cash flow needs and capital requirements. 3.2 PURPOSE OF ALM:-  Capture the maturity structure of the cash flows (inflows and outflows) in the Statement of Structural Liquidity  Tolerance levels for various maturities may be fixed by the bank keeping in view bank‘s ALM profile, extent of stable deposit base, nature of cash flows etc. 3.3 SIGNIFICANCE OF ALM:-  Volatility  Product Innovations & Complexities  Regulatory Environment  Management Recognition 3.4 WHAT DO YOU MEAN BY ALM??:- Active management of a bank's Balance Sheet to maintain a mix of loans and deposits consistent with its goals for long-term growth and risk management. Banks, in the normal course of business, assume financial risk by making loans at interest rates that differ from rates paid on deposits. Deposits often have shorter maturities than loans and adjust to current market rates faster than loans. The result is a balance sheet mismatch between assets (loans) and liabilities (deposits). The function of asset-liability management is to measure and control three levels of financial risk: Interest Rate Risk (the pricing difference between loans and deposits), Credit Risk (the probability of default), and Liquidity Risk (occurring when loans and deposits have different maturities).
  15. 15. Page | 15 A primary objective in asset-liability management is managing Net Interest Margin that is, the net difference between interest earning assets (loans) and interest paying liabilities (deposits) to produce consistent growth in the loan portfolio and shareholder earnings, regardless of short-term movement in interest rates. The dollar difference between assets (loans) maturing or re-pricing and liabilities (deposits) is known as the rate sensitivity Gap (or maturity gap). Banks attempt to manage this asset-liability gap by pricing some of their loans at variable interest rates. A more precise measure of interest rate risk is Duration which measures the impact of changes in interest rates on the expected maturities of both assets and liabilities. In essence, duration takes the gap report data and converts that information into present-value worth of deposits and loans, which is more meaningful in estimating maturities and the probability that either assets or liabilities will re-price during the period under review. Besides financial institutions, nonfinancial companies also employ asset-liability management, mainly through the use of derivative contracts to minimize their exposures on the liability side of the balance sheet. 3.5 TECHNIQUES OF ALM:- Asset Liability management is a very broad field targeting risk management, which includes assessment of various types of risk the current assets and the forthcoming liabilities are exposed to. This is of major importance to the banking and financial service industry. There are a number of risk management consulting firms that research and work in this field. They provide various optimization tools and software and risk assessment models, which assist in the asset-liability management process. There are various asset optimization and portfolio management models that can help and form a part of the asset liability management technique. In general an ALM technique involves defining of risk and return relative to liability portfolio. The key to asset liability management lies in the ability to design an asset portfolio that depends on the risk to which the investor is exposed i.e. to devise a portfolio perfectly correlated with the future liabilities of the investor. 3.6 DIFFERENCE BETWEEN ASSET MANAGMENT & LIABILITY MANAGEMENT:- Asset management involves the management of assets, such as investments or property. Liability management is the flip side of the coin: the management of debts, loans and mortgages for example. Most people and indeed most companies have a mixture of assets and liabilities to manage
  16. 16. Page | 16 in order to maximise their returns or their growth of wealth. If liabilities are ill-attended, they can result in forced sell-offs of assets and where liabilities are far greater than the assets of course, individuals can be considered to be very highly leveraged. 3.7 OBJECTIVE OF ALM:- The objective of asset and liability management is to develop and implement policies and processes to assist in:  identifying, acquiring, accurately valuing, managing and disposing of assets, and ensuring those assets are put to optimal use for purposes consistent with site objectives  identifying, incurring, accurately valuing, and meeting liabilities and ensuring those liabilities are only incurred for purposes consistent with agency objectives. 3.8 Categories of risk:- Risk in a way 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, and liquidity risk. These categories of financial risk require focus, since financial institutions like banks do have complexities and rapid changes in their operating environments. Although there are many risks involved with the business of the banks, yet Interest Rate Risk is a major case and has many impacts on the bank‘s business. Interest rate risk: Interest risk is the change in prices of bonds that could occur as a result of change: in interest rates. It also considers change in impact on interest income due to changes in the rate of interest. In other words, price as well as reinvestment risks require focus. In so far as the terms for which interest rates were fixed on deposits differed from those for which they fixed on assets, banks incurred interest rate risk i.e., they stood to make gains or losses with every change in the level of interest rates. The banking industry in India has substantially more issues associated with interest rate risk, which is due to circumstances outside its control. This poses extra challenges to the banking sector
  17. 17. Page | 17 and to that extent; they have to adopt innovative and sophisticated techniques to meet some of these challenges. 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. In the Indian context, 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 Interest Rate risk is the exposure of a bank‘s financial conditions to adverse movements of interest rates Though this is normal part of banking business, excessive interest rate risk can pose a significant threat to a bank‘s earnings and capital base Changes in interest rates also affect the underlying value of the bank‘s assets, liabilities and off-balance-sheet item Interest rate risk refers to volatility in Net Interest Income (NII) or variations in Net Interest Margin(NIM) NIM = (Interest income – Interest expense) / Earning assets. Sources of Interest Rate Risk
  18. 18. Page | 18 Re-pricing Risk: The assets and liabilities could re-price at different dates and might be of different time period. For example, a loan on the asset side could re-price at three-monthly intervals whereas the deposit could be at a fixed interest rate or a variable rate, but re-pricing half-yearly Basis Risk: The assets could be based on LIBOR rates whereas the liabilities could be based on Treasury rates or a Swap market rate Yield Curve Risk: The changes are not always parallel but it could be a twist around a particular tenor and thereby affecting different maturities differently Option Risk: Exercise of options impacts the financial institutions by giving rise to premature release of funds that have to be deployed in unfavourable market conditions and loss of profit on account of for closure of loans that earned a good spread. 3.9 ALM Core Functions - Managing Interest Rate Risk, Structural Gaps and Liquidity:- The ALM core function consists of managing maturity gaps and mismatches while managing interest rate risk within the overall mandate prescribed by ALCO. The key responsibilities and some typical actions initiated by the ALM team are dealt with in the following paragraphs: INTEREST RATE RISK BASIS RE- PRICING YIELD OPTIONS
  19. 19. Page | 19 1. Managing Structural Gaps In a financial institution with a mature ALM function, this is arguably the most critically and continuously monitored aspect, since the ALM Managers seek to manage the structural gaps in the Balance Sheet. While liquidity management focuses typically on short-term time ladders, the structural gap management shifts the focus on time ladders more than a year. This aspect of ALM stresses the importance of balancing maturities as well as cash flows on either side of balance sheet. It strategizes dynamically on balancing the gaps, issuing timely guidelines to adjust focus on ‗right‘ product types and tenors, and actively involve ALCO in this process. a. Static Gap: The ALM function takes into consideration assets maturing in short, medium and long time ladders and seeks to balance it vis-à-vis liabilities maturing across short, medium and long term ladders. The gaps reports typically point to funding gaps and excess funds at different points in time. The challenge with the ALM function is that the gaps are dynamically evolving and need continuous monitoring as the balance sheet changes every day. b. Duration: Duration is considered as a measure of interest rate sensitivity. However, for our immediate purpose, let us set aside interest rate sensitivity. Macaulay‘s duration is traditionally accepted as a good measure of ‗length‘ of portfolio or a measure of center of gravity of discounted cash-flows over life of an asset (or liability). It‘s common practice to measure duration of portfolio for different product types as well as on an overall portfolio level. It‘s useful to simulate how duration of portfolio will be affected by future events. c. Dynamic Gap: It is normal practice to rely on dynamic gap reports to simulate future gap positions for assumed business volumes and exercise of options (e.g., prepayments). In addition to proposed new volumes, prepayment transactions and assumed deposit roll-overs, the ALM manager would like to include a proposed hedge transaction. d. Long-Term Assets / Long-Term Liabilities Ratio: ALM practitioners prefer to focus on the ratio of assets and liabilities exceeding one year and often want to set acceptable limits around this. Where there are operative limits, the ALCO meetings will usually monitor the ratio, and the institution constantly endeavors to stay within a comfortable level around this limit. This
  20. 20. Page | 20 along with liquidity gaps help to bring in any imbalances and help maintain a structurally sound balance sheet. 2. Managing Interest Rate Sensitivity A financial institution typically relies on certain measures to evaluate and manage interest rate sensitivities. We deal with them below: a. Interest Rate Sensitivity Gap Reports: The ALM function seeks to monitor interest rate sensitivity by generating so-called interest rate sensitive gap reports, which provide a cash flow laddering based on re-pricing profile and frequency of interest rate sensitive assets and liabilities. b. Duration Measures: Modified duration seeks to measure net present value of a loan portfolio (simply bond price) under different interest rate conditions. For example, one seeks to analyze by how much percentage the bond price will be affected by a basis point up and down move in interest rates. The resulting outputs help us determine the modified duration or simply interest rate sensitivity of the net present value or bond price. c. DV01 or PVBP: This one is arguably the most popular measure among ALM practitioners. DV01 seeks to calculate the dollar value by which the market value is affected by a basis point expected movement in the interest rates. It‘s common to find leading banks setting internal limits around this measure to manage interest rate risk in the balance sheet. d. Net Interest Income (NII) Sensitivity: Financial institutions attach much importance to assessing the impact of interest rate changes, new business, change in product-mix and roll-over of deposits on net interest income. Income statements that allow for comparison of net interest income under different scenarios are immensely helpful in understanding the impact of mild market movements and shocks on the income statement as well as balance sheet 3. Managing Liquidity Typically, the ALM function seeks to generate daily gaps on short-term ladders and ensures that cumulative gaps operate within pre-set limits. Of course, managing liquidity gaps alone is not adequate. A well managed liquidity function will include liquidity contingency plan, liquid asset buffers and setting liquidity policies and limits in tune with level of risk that the management believes is acceptable and manageable. 4. ALCO Reporting In most banks, ALCO meets at pre-determined intervals and the agenda is usually pre- determined. In order that ALCO meetings are effective, the ALCO pack (comprehensive in many
  21. 21. Page | 21 cases) is distributed in advance and reviewed in the meeting. The reports include some of what is listed above and certain other reports. The ALCO function is critical to ALM function and serves as the reviewing and approving authority for several key decisions including balance sheet structure, gap analysis, capital adequacy ratios and above all pro-active management of Balance Sheet. 5. Funds Transfer Pricing (FTP) A healthy FTP mechanism is part of a healthy ALM solution FTP helps to ensure the demarcation between market risk and credit risk by passing on the appropriate cost of funds to respective owners of risk. In recent years, focus has been placed on not just the base FTP, but also on including FTP add-ons like liquidity premium and similar adjustments. Financial institutions appear to be reviewing their FTP practices including the basis for liquidity premium both as a result of process improvement and increasing regulatory interest. 3.10 Key Components of ALM Solution:- 1. Cash-flow Engine: A significant aspect of ALM consists of forecasting and generating future cash flows based on historical data and assumed scenarios. A time tested cash flow engine that‘s capable of modeling a wide range of financial products on and off the Balance Sheet is a crucial part of an ALM solution. 2. Unified Data Model: Having a pre-defined, financial products-specific and time tested analytics data model accelerates implementation by providing a head-start. Further it helps leverage and makes much wider use of data for a wider range of analytics apart from ALM. This is useful especially considering that enterprise-wide time series data at a granular level is stored in our analytical applications over time. 3. Market Rates and Economic Scenarios: Define external economic indicators as well as define interest rate scenarios and forecast rate movements. Maintain economic assumptions separately to quickly develop alternative forecasts and stress test the Balance Sheet under alternative environments. 4. Deterministic and Stochastic Analysis: There are broadly two approaches to making ALM forecasts. In the deterministic approach, the user makes explicit assumptions about interest rate movements and forecasts interest rates and currency exchange rates for various scenarios and different term points. In Stochastic scenario, the forecast rates are modeled using Monte Carlo simulation method and the output is then generated at desired confidence intervals.
  22. 22. Page | 22 The modeling framework additionally allows for simulating the impact of hedging strategies and in forecasting what a gap report generated at a future point in time will look like. 5. Behavior Modeling: The contractual behavior alone is not adequate in modeling the Balance Sheet. It is essential to take into consideration behavioral maturity based on historical observations in order that cash flow predictions are more reliable and in tune with demonstrated behavioral trends. This applies to core and non-core parts in current and savings accounts, deposit roll-over assumptions and prepayment assumptions. It is also possible to develop a model for behavioral trends using certain additional and optional infrastructure components. This tends to be a separate and more involved stream of the project. 6. Powerful Analytical Reporting: A comprehensive, pre-built set of reports is available, including static, dynamic and interest rate sensitive gap reports, market value and economic value added reports, duration reports, NII reports and stochastic reports, and liquidity risk reports. 3.11 Asset-liability management strategies for correcting mismatch:- The strategies that can be employed for correcting the mismatch in terms of D(A) > D(L) can be either liability or asset driven. Asset driven strategies for correcting the mismatch focus on shortening the duration of the asset portfolio. The commonly employed asset based financing strategy is securitization. Typically the long-term asset portfolios like the lease and hire purchase portfolios are securitized; and the resulting proceeds are either redeployed in short term assets or utilized for repaying short-term liabilities. Liability driven strategies basically focus on lengthening the maturity profiles of liabilities. Such strategies can include for instance issue of external equity in the form of additional equity shares or compulsorily convertible preference shares, issue of redeemable preference shares, subordinated debt instruments, debentures and accessing long term debt like bank borrowings and term loans. Strategies to be employed for correcting a mismatch in the form of D(A) < D(L) . Asset driven strategies focus on lengthening the maturity profile of assets by the deployment of available lendable resources in long-term assets such as lease and hire purchase. Liability driven strategies focus on shortening the maturity profile of liabilities, which can include, liquidating bank
  23. 23. Page | 23 borrowings which are primarily in the form of cash credit (and hence amenable for immediate liquidation), using the prepayment options (if any embedded in the term loans); and the call options, if any embedded in bonds issued by the company; and raising short-term borrowings (e.g.: fixed deposits with a tenor of one year) to repay long-term borrowings. The Problem Of Mismatch • Mismatches in maturity • Mismatches in interest rate • Maturity mismatch is the basis of profitability • Risk management does not eliminate mismatch – merely manages them • Interest Rate Risk à Affects profitability • Liquidity Risk à May lead to liquidation • General Strategy  Eliminate Liquidity Risk (not the mismatch)  Manage Interest Rate Risk Asset Liability Transformation • Banks are exposed to credit and market risks in view of the asset-liability transformation • With liberalisation, banks‘ operations have become complex and large , requiring strategic management. Asset - Liability Management System in banks - Guidelines Over the last few years the Indian financial markets have witnessed wide ranging changes at fast pace. Intense competition for business involving both the assets and liabilities, together with increasing volatility in the domestic interest rates as well as foreign exchange rates, has brought pressure on the management of banks to maintain a good balance between profitability and long- term viability. These pressures call for structured and comprehensive measures and not just action. The Management of banks has to base their business decisions on a dynamic and integrated risk management system and process, driven by corporate strategy. Banks are exposed to several major risks in the course of their business - credit risk, interest rate risk, foreign exchange risk, equity / commodity price risk, liquidity risk and operational risks. The initial focus of the ALM function would be to enforce the risk management
  24. 24. Page | 24 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. 3.12 The ALM process rests on three pillars:- ALM information systems => Management Information System => Information availability, accuracy, adequacy and expediency ALM organisation => Structure and responsibilities => Level of top management involvement ALM process => Risk parameters => Risk identification => Risk measurement => Risk management => Risk policies and tolerance levels. ALM INFORMATION SYSTEMS ALM ORGANIZATION ALM PROCESS
  25. 25. Page | 25 3.13 Revised ALM Policy:- {Broad parameters of the ALM Policy} The ALM policy of the Bank aims at: Providing a comprehensive and dynamic framework for identifying, measuring, monitoring and managing market risks(both under normal and stressed scenarios) that needs to be closely integrated with the Bank‘s business strategy. Assesment of market and liquidity risks and altering the asset liability profile in a dynamic way in order to protect NII in short run and Market Value of Equity in the long term. Setting up organizational framework for risk management and monitoring. Efficient liquidity risk management to ensure the bank‘s ability to meet its liabilities as they become due and also in crisis scenarios. Measuring interest rates sensitivity of assets and liabilities to ascertain the impact of change in interest rate on Bank‘s net Interest Income(NII). Components of a bank balance sheet LIABILITIES ASSETS Capital Cash &Balances Reserve and surplus Bal with Bank& Money at call and short notices Deposits Investments Borrowings Advances Other Liabilities Fixed Assets Other Assets Bank’s profit and loss account A bank‘s profit & Loss Account has the following components: I. Income: This includes Interest Income and Other Income.
  26. 26. Page | 26 II. Expenses: This includes Interest Expended, Operating Expenses and Provisions & contingencies 3.14 WHY IS ALM ESSENTIAL FOR BANKS?:- ALM answers three key questions: 1) How much risk does the bank want to take? This is determined by the ALCO committee to best describe the risk appetite of the bank. 2) How much risk does the bank have now? This is determined by employing quantitative tools to measure the risks of the bank‘s assets and liabilities. 3) How do we move from our current risk profile to our target risk profile? This is determined by assessing the risk-response options available to the bank as part of the ALM process. ALM is a unique, total balance sheet approach to managing important risks at the enterprise level. ALM deals with the management of all market risks that result from a bank‘s structural position. This position is primarily created by the bank‘s intermediation between depositors and borrowers. While ALM is most important for retail and universal banks, a growing trend has seen ALM introduced to trading or investment banks as well. ALM is different from the management of market risk in trading operations because ALM positions are regarded as being comparatively illiquid to the trading portfolio; however, these trading positions could be incorporated into the total balance sheet view of ALM. Most banks hold a significant portion of their business in illiquid positions held over a longer term making an ALM process essential to increased capital efficiency and competitiveness in the market. By modeling ALM risks, banks are seeking to both minimize risk for a given level of target return and to know how much to charge customers to fund the capital consumed by these risks. Another task of ALM is to determine and minimize the internal interest rates that should be charged between the bank‘s business units when they lend funds to each other. This concept, called Funds Transfer Pricing (FTP), is the first step toward profitability and performance measurement across product and business lines; it helps the bank determine the component sources of the overall net interest margin.
  27. 27. Page | 27 The primary risks associated with an ALM process are interest rate risk and funding liquidity risk. ALM could also, to a lesser extent, include currency and commodity price risk and it typically incorporates other important balance sheet drivers into the process, such as funding and capital planning, regulatory constraints, taxation and profitability and growth. To mitigate interest rate risks, a bank can respond with a variety of core business decisions on balance sheet solutions that involve product mix and pricing of loans, deposits and other borrowings. Or they may reply that the interest rate risk is due to discretionary business decisions on-balance sheet investment or funding strategies that involve rate characteristics or the maturity mix of wholesale funding or investment strategies. A third reply to interest rate risk would be off- balance sheet items, such as derivatives like interest rate swaps, caps, floors, etc. Both interest rate risk and funding liquidity risk are due to the differences between the bank’s assets and liabilities. 3.15 ALM PRACTICES:- Often banks rely on poorly documented internal IT systems understood by only a select few within the organization. Many banks in Asia Pacific use outdated Excel spreadsheet systems comprised of multiple worksheet components. The resulting challenges of system maintenance, additional risk reporting metrics and process improvement quickly cause operational problems when (inevitably) employee turnover occurs. Moreover, as central banks issue additional regulatory requirements and guidance, these systems are poorly designed and staffed to meet the evolving regulatory landscape in a timely way. In short, the risk management challenges of ALM that exist in a fluid, dynamic, and constantly evolving market climate are treated with a process that is rigidly defined and static. Even worse, a large percentage of banks still perform no regular analysis at all, or they rely on measurements purely from historical results to approximate a view of the perceived risk exposures in the balance sheet. The reality at these banks is that output from such a primitive process is summarily dismissed or ignored during Asset Liability Committee (ALCO) Meetings. Few banks are willing to base strategic decision-making and risk-response from risk profiles of the balance sheet that are not complete or relevant. Lacking the ALM process to manage the interest rate term structure and optimize the risk-return profile, these banks have become warehouses of
  28. 28. Page | 28 risk, collecting interest-rate and liquidity sensitivities resulting from an unmanaged organic risk- taking process. Of those institutions that do run a formal software system, many still operate the original assumptions for forecasting and planning, and reporting requirements from the initial implementation. Here he ALM investment is restricted to the execution of the system and not to the process of managing the ALM model - analyzing critical output, and driving better decision-making by integrating risk measurement to the risk management response as defined by the risk policy and appetite of the bank. This leads to a vicious cycle as internal teams fail to develop the capabilities to change and manage model assumptions and reporting criteria, or perform any evaluation of model risk or assumptions risk through back-testing and stress testing exercises. ALM system capabilities inevitably decline as they are not updated, usually due to the bank‘s fear of the unknown. 3.16 MAKING ALM USEFUL TO THE BANK:- Regulatory reporting is important and the ability to capture full reporting requirements in an effortless way in the ALM system should be an important consideration. Adopting an ALM system earns goodwill with bank regulators and avoids unnecessary capital charges for not fully covering interest rate risk exposures. The real value in an ALM system is the expected improvement and benefit to operating margins, increased efficiency and precision in risk management processes. ALM is the first step on the important road to developing business line and product profitability measures on a risk-adjusted basis. With an ALM system, the bank has the ability to simulate not only stress scenarios, but also non-parallel shifts, twists and inversions. Many of the tragic stories from financial institutions who failed to properly employ an ALM system stem from assumptions about market correlations that simply cannot be relied upon during extreme conditions. A properly devised ALM process will contain not only regulatory scenarios executed on a periodic basis, but also a series of strategic scenarios based on current market conditions or evolving bank activity trends that suggest increased risk mitigation or vulnerability. A general rule of thumb in ALM modeling is to keep model assumptions as simple, straightforward and auditable as possible. If a given process of assumptions development and maintenance produces the opposite result, the ALCO committee should be very keen to get involved and ask the business team some pointed questions. This approach represents a role change for ALCO committee members from primary reviewers of ALM policy, analysis and strategy to active participants who guide the risk management team toward appropriate strategies for
  29. 29. Page | 29 maximizing the link between model assumptions, review and utility and overall risk management strategy. 3.17 Strengthening points for ALM:-  Short and long-term minimum capital or equity/total assets goal ratios.  The maximum percentage of assets to be held by any one client, in different types of loans and investments, in fixed rate investments and loans with a maturity greater than one year, and invested in fixed assets.  The desired diversification of savings and deposits to eliminate potential concentration risk (having too much in any one type of deposit or with any one client).  Maximum maturities for all types of loans, investments, and deposits.  Establishment of fixed or variable interest rate loans and deposits.  Pricing strategies for loans and savings products that are based on what it actually costs to offer the products and what the local market will bear. 3.18 SUCCESS OF ALM IN BANKS: PRE –CONDITIONS:-  Awareness for ALM in the Bank staff at all levels–supportive Management & dedicated Teams.  Method of reporting data from Branches/ other Departments. (Strong MIS).  Computerization-Full computerization, networking.  Insight into the banking operations, economic forecasting, computerization, investment,credit.  Linking up ALM to future Risk Management Strategies. Asset-Liability Management has evolved as a vital activity of all financial institutions and to some extent other industries too. It has become the prime focus in the banking industry, with every bank trying to maximize yield and reduce their risk exposure. The Reserve Bank of India has issued guidelines to banks operating in the Indian environment to regulate their asset-liability positions in order to maintain stability of the financial system. Maturity-gap analysis has a wide range of focus, not only as a situation analysis tool, but also as a planning tool. Banks need to maintain the maturity gap as low as possible in order to avoid any liquidity exposure. This would necessarily mean that the outflows in different maturity buckets need to be funded from the inflows in the same bucket. As per the RBI‘s guidelines, banks have to
  30. 30. Page | 30 maintain a stable liquidity position in the short term duration, including both 1-14 days and 15-28 days time buckets, to ensure the stability and credibility of the banking system of the country. CHAPTER-4: CASE STUDY
  31. 31. Page | 31 INTEREST RATE RISK MANAGEMENT IN SBI BANK The bank has three dedicated groups, the Global Risk Management Group (GRMG), the Compliance Group and the Internal Audit Group which are responsible for assessment, management and mitigation of risk in the bank. In addition, the Credit and Treasury Middle Office Groups and the Global Operations Group monitor operational adherence to regulations, policies and internal approvals. These groups are accountable to the Risk and Audit Committees of the Board of Directors. GRMG is further organised into the Global Credit Risk Management Group and the Global Market & Operational Risk Management Group. Interest rate risk is measured through the use of re-pricing gap analysis and duration analysis. Liquidity risk is measured through gap analysis. Since the bank‘s balance sheet consists predominantly of rupee assets and liabilities, movements in domestic interest rates constitute the main source of interest rate risk. Exposure to fluctuations in interest rates is measured primarily by way of gap analysis, providing a static view of the maturity and re-pricing characteristics of balance sheet positions. An interest rate gap report is prepared by classifying all assets and liabilities into various time period categories according to contracted maturities or anticipated re-pricing date. The difference in the amount of assets and liabilities maturing or being re-priced in any time period category, would then give an indication of the extent of exposure to the risk of potential changes in the margins on new or re-priced assets and liabilities. SBI Bank prepares interest rate risk reports on a fortnightly basis. These reports are submitted to the Reserve Bank of India on a monthly basis. Interest rate risk is further monitored through interest rate risk limits approved by the Asset Liability Management Committee. The bank‘s core business is deposit taking and lending and these activities expose it to interest rate risk. The bank‘s primary source of funding is deposits and, to a smaller extent, borrowings. GAP ANALYSIS TECHNIQUE Gap analysis is a technique of asset-liability management that can be used to assess interest rate risk or liquidity risk. It measures at a given date the gaps between rate sensitive liabilities (RSL) and
  32. 32. Page | 32 rate sensitive assets (RSA) (including off-balance sheet positions) by grouping them into time buckets according to residual maturity or next repricing period, whichever is earlier. An asset or liability is treated as rate sensitive if i) within the time bucket under consideration, there is a cash flow; ii) the interest rate resets/reprices contractually during the time buckets; iii) administered rates are changed and iv) it is contractually prepayable or withdrawal allowed before contracted maturities. Thus, Gap = RSA – RSL; Gap Ratio = RSAs/RSLs. This gap is used as a measure of interest rate sensitivity. The positive or negative gap is multiplied by the assumed interest changes to derive the Earnings at Risk (EaR). A bank benefits from a positive Gap (RSA>RSL), if interest rate rises. Similarly, a negative Gap (RSA<RSL) is advantageous during the period of falling interest rate. The interest rate risk is minimized if the gap is near zero. Gap analysis was widely adopted by financial institutions during the 1980s. When used to manage interest rate risk, it was used in tandem with duration analysis. Both techniques have their own strengths and weaknesses. Duration analysis summarizes, with a single number, exposure to parallel shifts in the term structure of interest rates. Though gap analysis is more cumbersome and less widely applicable, it addresses exposure to other term structure movements, such as tilts or bends. It also assesses exposure to a greater variety of term structure movements. Table-I Selected Items from the P&L A/c and Balance Sheet for the years 2010-11,2011-12, 2012-13 Rs. In Crores Items 2010-11 2011-12 2012-13 Interest 48,867.96 63,230.37 75,325.80 Interest Earned 81,394.36 106,521.45 119,657.10 Provisions & Liabilities 105,248.39 80,915.09 95,455.07 Deposits 933,932.81 1,043,647.36 1202,739.57 Borrowings 119,568.96 127,005.57 169,182.71 Advances 756,719.45 867,578.89 1,045,616.55
  33. 33. Page | 33 • Interest rate for assets has been arrived at taking into account advances & investment portfolio and the interest earnings of the bank for the respective years. i.e.,Interest Rate = (Interest Earned) / (Total Advances – NPA + Total Investment). • Interest rate for liabilities has been arrived at taking into account the deposits & borrowings portfolio and the interest expenditure of the bank for the respective years. i.e., Interest Rate = (Interest Expended) / (Total Deposits + Total Borrowings). Net Interest Income (NII), Net Interest Margin (NIM), Gap and Net Income (NI) for 2010-11 to 2011-12 should be calculated. The formulae used are NII = (Rate of RSA * Volume of RSA) + (Rate of FRA * Volume of FRA) - (Rate of RSL * Volume of RSL) - (Rate of FRL * Volume of FRL) NIM = NII/Total Performing Assets GAP = RSA – RSL NI = NII – Provisions & Contingencies GAP Position Change in Interest Rates Change in Interest income Change in Interest expenses Change in NII 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 Data Insufficiency became a major limitation in the study due to which mainly the RSA & RSL couldn‘t be calculated. As a result many other observations couldn‘t be done. Although not completely, the further proceedings are done with the available data. ALM initiative in India Reserve Bank of India has made mandatory for banks with effect from 2002 – 03  To form ALCO (Asset-Liabilities Committee) as a committee of the Board of Directors  To track, monitor and report ALM Investments 295,600.57 312,197.61 350,927.27
  34. 34. Page | 34 Indian Scenario  While most of the banks in other economies began with strategic planning for asset  liability management as early as 1970, the Indian banks remained unconcerned about the  same. Till eighties, the Indian banks continued to operate in a protected environment. In  fact, the deregulation that began in international markets during the 1970s almost  coincided with the nationalization of banks in India during 1969. Nationalization brought  a structural change in the Indian banking sector. Wholesale banking paved the way for  retail banking and there has been an all-round growth in branch network, deposit  mobilization and credit disbursement. The Indian banks did meet the objectives of  nationalization, as there was overall growth in savings, deposits and advances. But all this  was at the cost of profitability of the banks. Quality was subjugated by quantity, as loan  sanctioning became a mechanical process rather than a serious credit assessment  decision. Political interference has been an additional malady. A typical study is done on ALM keeping focus on Basel-II accord as it deals with many important points regarding ALM in commercial banks. Paradigm Shift As the real sector reforms began in 1992, the need was felt to restructure the Indian banking industry. The reform measures necessitated the deregulation of the financial sector, particularly the banking sector. The initiation of the financial sector reforms, brought about a paradigm shift in the banking industry. The Narasimham Committee report on the banking sector reforms highlighted the weaknesses in the Indian banking system and suggested reform measures based on the Basle norms. The guidelines that were issued subsequently laid the foundation for the reformation of Indian banking sector. The deregulation of interest rates and the scope for diversified product profile gave the banks greater leeway in their operations. New products and new operating styles exposed the
  35. 35. Page | 35 banks to newer and greater risks. Though the types of risks and their dimensions grew, there was not much being done by the banks to address the situation. At this point, the Reserve Bank of India, the chief regulator of the Indian banking industry, has donned upon itself the responsibility of initiating risk management practices by banks. Moving in this direction, the RBI announced the prudential norms relating to Income Recognition, Asset Classification and Provisioning and the Capital Adequacy norms, for the banks. These guidelines ensured that the Indian banks followed international standards in risk management. The Prudential norms and the Capital Adequacy norms are expected to ensure safety and soundness of the banks. On a closer observation, these norms however, tackle the risks at a macro level. The capital and the provisions serve as a cushion to the banks and ensure that they sustain in the long run. But, banks do face risks in their day-to-day transactions, which alter their assets and liabilities on a continuous basis. The developments that have taken place since liberalization have further led to a remarkable transition in the risk profile of the financial intermediaries. The changes in the profile of the sources and uses of funds are reflected in the borrower's profile, the industry profile and the exposure limits for the same, interest rate structure for deposits and advances, etc. This not only has led to the introduction of discriminate pricing policies, but has also highlighted the need to match the maturities of the assets and liabilities. The main reasons for the growing significance of ALM are volatility in operating environment, product innovations, regulatory prescriptions, enhanced awareness of top management, high percentage of the non-performing loans in India attributed to the stringent asset classification norms, which the Indian banks follow. Asset Liability Management is strategic balance sheet management of risks caused by changes in the interest rates, exchange rates and the liquidity position of the bank. To manage these risks, banks will have to develop suitable models based on its product profile and operational style. Ironically, many Indian banks are yet not ready to take the required initiative for this purpose. Though the reasons for such lack of initiative are varied, one important reason can be that the management of the banks has so far been in a protected environment with little exposure to the open market. It was lack of technology and inadequate MIS, which prevented banks from moving towards effective ALM. The apathy on the part of the banks made it imperative for the RBI to step in and push the process. Basel II Accord: Impact On Indian Banks Pillar 1 (minimum capital requirements): It spells out the capital requirement of a bank in relation to the credit risk in its portfolio, which is a significant change from the ―one size fits all‖
  36. 36. Page | 36 approach of Basel I. Pillar 1 allows flexibility to banks and supervisors to choose from among the Standardized Approach, Internal Ratings Based Approach, and Securitization Framework methods to calculate the capital requirement for credit risk exposures. Besides, Pillar 1 sets out the allocation of capital for operational risk and market risk in the trading books of banks. Pillar 2 (supervisory oversight): It provides a tool to supervisors to keep checks on the adequacy of capitalization levels of banks and also distinguish among banks on the basis of their risk management systems and profile of capital. Pillar 2 allows discretion to supervisors to (a) link capital to the risk profile of a bank; (b) take appropriate remedial measures if required; and (c) Ask banks to maintain capital at a level higher than the regulatory minimum. Pillar 3 (market discipline and disclosures): It provides a framework for the improvement of banks‘ disclosure standards for financial reporting, risk management, asset quality, regulatory sanctions, and the like. The pillar also indicates the remedial measures that regulators can take to keep a check on erring banks and maintain the integrity of the banking system. Further, Pillar 3 allows banks to maintain confidentiality over certain information, disclosure of which could impact competitiveness or breach legal contracts. It provides a framework for the improvement of banks‘ disclosure standards for financial reporting, risk management, asset quality, regulatory sanctions, and the like. 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). Typically, a bank’s corporate loan portfolio including cash credit and working capital demand loans has mostly unrated exposures. External ratings are used more in the investment portfolio, for investing in debentures, bonds, and commercial paper (typically A1+/A1), lowering the proportion of unrated exposures. Thus, implementation of Basel II would result in a marginally lower credit risk weights and a marginal release in regulatory capital needed for credit risk. As a result, we expect for most banks, Basel II would result in reduction in regulatory credit risk weights. However, if the banks were to significantly increase their retail exposures or get external ratings for the short-term exposures (cash credit, overdraft and working capital demand loans), the credit risk weights could decline significantly.
  37. 37. Page | 37 Operational Risk Capital allocation would be a drag on capital for Indian banks Basel II has indicated three methodologies for measuring operational risk:  Basic Indicator Approach;  Standardized Approach; and  Advanced Measurement Approach (AMA). RBI has clarified that banks in India would follow the Basic Indicator Approach to begin with. Subsequently, only banks that are able to demonstrate better risk management systems would be asked to migrate to the Standardised Approach and AMA. Internationally, in the US, as various papers indicate, very few banks would eventually migrate to AMA, whereas in the EU, regulators have stated that they would make AMA mandatory for banks under their jurisdiction. The Basic Indicator approach specifies that banks should hold capital charge for operational risk equal to the average of the 15% of annual positive gross income over the past three years, excluding any year when the gross income was negative. Gross income is defined as net interest income and non- interest income, grossed up for any provisions, unpaid interests and operating expenses (such as fees paid for outsourced services). It should only exclude treasury gains/losses from banking book and other extraordinary and irregular income (such as income from insurance). Basis of ALM  Traditional system of Accrual Accounting in Banks  The method disguised possible risks arising from how the assets and liabilities were structured Example  Saral Bank borrows Rs 100 mn for 1 yr @ 6.00% p.a. and lends to Reputation Ltd. for 5 yrs @ 6.20% p.a.  Gain (seemingly): 20 bps  Risk entailed in transaction: borrow again at the end of 1 yr to finance the loan which still has 4 more yrs to mature  Interest rate for 4 yrs maturity at the end of 1 yr: 7.00% p.a.  What happens??  Earn – 6.20% p.a. & Pay – 7.00% p.a.!!  Accrual method of accounting  Asset = 100*(1.062) = Rs 106.2 mn
  38. 38. Page | 38  Liability = 100*(1.060) =Rs 106 mn  Earnings = 106.2 – 106 =Rs 0.2 mn  Market Value method of accounting  Asset = 100*(1.062)^5/ (1.070)^4 = 96.72 mn  Liability = 100*(1.060) = Rs 106 mn  Loss = Rs 9.28 mn  Root cause of problem – Mismatch between Assets & Liabilities  ALM Components
  40. 40. Page | 40 5.1 Findings 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 practices.  Among all groups, SBI & Associates have best asset- liability maturity pattern.  They have the best correlation between assets and liabilities.  Other than Foreign Banks - all other banks can be called liability managed banks.  They all borrow from money market to meet their maturing liabilities.  Across all banks Fixed Asset and Net Worth are highly correlated.  All banks have proportionate Net worth and investment in Fixed Asset.  Private Banks are aggressive in profit generation e Banks have better Net Profit Margin and. Return on Net worth.  Private Banks have greater equity multiplier than public sector banks, which reflects extra leverage that they have.  After 2002, public sector banks are catching up with private banks.
  41. 41. Page | 41 5.2 Suggestions:- 1. 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. 2. Banks should make sure that increased balance sheet size should not result in excessive asset liability mismatch resulting in volatility in earnings. 3. 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. 4. The effectiveness of ALM system should be improved with a good Fund Transfer Pricing system. 5. Have a younger person, enthusiastic in nature as ALCO secretary. This person is responsible for all pre-ALCO analysis and distribution of ALM reports to relevant people. 6. Do not deliberate a lot over non-term product distribution. It is anyway a probabilistic cash flow. Worry more about systems in place to constantly review this. 7. ALM sheet item granularity depends on distribution for non-term products. For example, ‗savings bank‘ may be one heading or ‗savings bank – salaries‘ could be the level at which distribution of volatility differs. Thus, discuss these items beforehand. 8. Define functional objectives completely before starting this project. Do not keep tampering with it. 9. Senior management may refer to well known books on this subject to get a quick revision. 10. Do not over-engineer your ALM sheet. Let it evolve. 11. Results of ALM are visible over a couple of years. Keep measuring what is required.
  42. 42. Page | 42 5.3 Conclusion Based on the empirical findings, it can be concluded that ownership and structure of the banks do have a major bearing in the ALM procedure. It is further observed that SBI and its Associates have the best correlation, thereby indicating the best asset-liability maturity pattern. Most of the Indian banks, unlike foreign banks, are liability-managed banks because they all borrow from money market to meet their maturing liabilities. The private banks are highly aggressive for profit generation and use the short-term funds for long-term investments. The interest rate and liquidity risks are the significant risks that affect the bank‘s balance sheet and therefore, they should be regularly evaluated and managed. For the private banks, they use a risky strategy in case of problems arising from the significant risks as has been mentioned above. The nationalized banks along with SBI and its Associates are excessively concerned about liquidity and in the process; they use long-term funds for long- as well as medium- and short-term loans. The MIS of banks should be strengthened up to the mark.
  43. 43. Page | 43 BIBLIOGRAPHY:-  RBI WEBSITE  ASIA PACIFIC JOURNAL ON ALM  DASH M, VENKATESH K.A, BHARGAVA B.D; ―AN ANALYSIS OF ASSET- LIABILITY MANAGEMENT IN INDIAN BANKS‖; WWW.SSRN.COM  RAO , A.V. (2005); ―ALM SYSTEMS IN BANKS,‖ TREASURY MANAGEMENT.  Vaidyanathan, R. (1999); ―Asset-Liability Management: Issues and Trends in the Indian Context,‖ ASCI Journal of Management, 29(1).   ALM STRATEGIC & REGULATORY ISSUES FOR BANKS  ORACLE FINANCIAL SERVICES    Sinkey, J.F. (1992). ―Commercial bank financial management‖ (4th Ed ) New York: Maxwell Macmillan International Edition  Vaidya, P. and Shahi, A (2001); ―Asset Liability Management in Indian Banks,‖ Spandan.