1) Asset/liability management (ALM) is the process of making decisions about the composition of a bank's assets and liabilities in order to manage risks and ensure sustainable profits. 2) ALM decisions are typically made by a bank's asset/liability management committee (ALCO) and involve strategic balance sheet management to match assets and liabilities. 3) The goal of ALM is to manage sources and uses of funds with respect to interest rate risk and liquidity risk arising from mismatches between assets and liabilities.

1. Risk in Balance Sheet of a Bank-
Introduction to ALM
ग ाँव बढ़े तो देश बढ़े www.nabard.org /nabardonline Taking Rural India >> Forward
K. R. Chandra
Faculty Member
BIRD

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 assessment
2

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 www.nabard.org /nabardonline Taking Rural India >> Forward

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. 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. 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. 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 www.nabard.org /nabardonline Taking Rural India >> Forward

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 www.nabard.org /nabardonline Taking Rural India >> Forward

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 www.nabard.org /nabardonline Taking Rural India >> Forward

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 www.nabard.org /nabardonline Taking Rural India >> Forward

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 www.nabard.org /nabardonline Taking Rural India >> Forward
Why Manage risk?

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 www.nabard.org /nabardonline Taking Rural India >> Forward
Why Manage risk?- contd….

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 www.nabard.org /nabardonline Taking Rural India >> Forward
Different risks???

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 www.nabard.org /nabardonline Taking Rural India >> Forward
Different risk in Banks

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. 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. 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. 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. 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. • 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 www.nabard.org /nabardonline Taking Rural India >> Forward
How to Manage??..

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 www.nabard.org /nabardonline Taking Rural India >> Forward

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. 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. 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 www.nabard.org /nabardonline Taking Rural India >> Forward

25. • How to go about?
• How to gear ourselves up?
• Let us try
• See this video
26ग ाँव बढ़े तो देश बढ़े www.nabard.org /nabardonline Taking Rural India >> Forward

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. 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).
Concept of ALM

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. ALM Objectives
Liquidity Risk Management.
Interest Rate Risk Management.
Currency Risks Management.
Profit Planning and Growth Projection.

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. 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. 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. LIQUIDITY RISK
• METHODOLOGIES FOR MEASUREMENT
• Liquidity index
• Peer group comparison
• Gap between sources and uses
• Maturity ladder construction

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. MATURITY PROFILE-LIQUIDITY
• Outflows
• Capital, Reserves & Surplus
• Deposits
• Borrowings and bonds
• Other liabilities

36. MATURITY PROFILE-LIQUIDITY
• Inflows
• Cash
• Balance with RBI
• Balance with other banks
• Investments
• Advances

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. 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. 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. IMPACT ON NII
Gap Interest rate Change Impact on NII
Positive Increases Positive
Positive Decreases Negative
Negative Increases Negative
Negative Decreases Positive

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. 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. Gap Analysis
Modified Gap Analysis
Duration Gap Analysis
Value at Risk (VaR)
Simulation
Tools for ALM System

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. 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. 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. 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. 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

49. CALCULATION OF NII/NIM
• NII: INT.EARNED-INT. EXPENDED
• INT. EARNED: ADV+INVEST+BALANCE WITH RBI
• INT. EXPENDED:DEPOSITS+INT. ON RBI BORROWINGS
• NIM= (NII/TOT.EARNING ASSET)X100

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. THANK YOU
3ग ाँव बढ़े तो देश बढ़े www.nabard.org /nabardonline Taking Rural India >> Forward