6th unit Principles and Practices of Banking

1. Asset Liability Management in
Banks

2. Components of a Bank Balance Sheet
Liabilities Assets
1. Capital
2. Reserve & Surplus
3. Deposits
4. Borrowings
5. Other Liabilities
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

3. Banks profit and loss account
A bank’s profit & Loss Account has the following
components:
I. Income: This includes Interest Income and Other
Income.
II. Expenses: This includes Interest Expended,
Operating Expenses and Provisions &
contingencies.

4. Evolution
 In the 1940s and the 1950s, there was an abundance of funds in
banks in the form of demand and savings deposits. Hence, the focus
then was mainly on asset management
 But as the availability of low cost funds started to decline, liability
management became the focus of bank management efforts
 In the 1980s, volatility of interest rates in USA and Europe caused
the focus to broaden to include the issue of interest rate risk. ALM
began to extend beyond the bank treasury to cover the loan and
deposit functions
 Banks started to concentrate more on the management of both sides
of the balance sheet

5. What is Asset Liability Management??
 The process by which an institution manages its balance
sheet in order to allow for alternative interest rate and
liquidity scenarios
 Banks and other financial institutions provide services
which expose them to various kinds of risks like credit
risk, interest risk, and liquidity risk
 Asset-liability management models enable institutions to
measure and monitor risk, and provide suitable
strategies for their management.

6.  An effective Asset Liability Management Technique aims to manage the
volume, mix, maturity, rate sensitivity, quality and liquidity of assets and
liabilities as a whole so as to attain a predetermined acceptable risk/reward
ratio
 It is aimed to stabilize short-term profits, long-term earnings and long-term
substance of the bank. The parameters for stabilizing ALM system are:
1. Net Interest Income (NII)
2. Net Interest Margin (NIM)
3. Economic Equity Ratio

7. 3 tools used by banks for ALM
ALM information
systems
ALM Organization
ALM Process

8. ALM Information Systems
 Usage of Real Time information system to gather the information
about the maturity and behavior of loans and advances made by all
other branches of a bank
 ABC Approach :
 analysing the behaviour of asset and liability products in the
top branches as they account for significant business
 then making rational assumptions about the way in which
assets and liabilities would behave in other branches
 The data and assumptions can then be refined over time as the
bank management gain experience
 The spread of computerisation will also help banks in
accessing data.

9. ALM Organization
 The board should have overall responsibilities and should set the limit for
liquidity, interest rate, foreign exchange and equity price risk
 The Asset - Liability Committee (ALCO)
 ALCO, consisting of the bank's senior management (including
CEO) should be responsible for ensuring adherence to the limits
set by the Board
 Is responsible for balance sheet planning from risk - return
perspective including the strategic management of interest rate
and liquidity risks
 The role of ALCO includes product pricing for both deposits and
advances, desired maturity profile of the incremental assets and
liabilities,
 It will have to develop a view on future direction of interest rate
movements and decide on a funding mix between fixed vs floating
rate funds, wholesale vs retail deposits, money market vs capital
market funding, domestic vs foreign currency funding
 It should review the results of and progress in implementation of
the decisions made in the previous meetings

10. ALM Process
Risk Parameters
Risk Identification
Risk Measurement
Risk Management
Risk Policies and Tolerance
Level

11. Categories of Risk
 Risk is the chance or probability of loss or
damage
Credit Risk Market Risk Operational Risk
Transaction Risk
/default risk
/counterparty risk
Commodity risk Process risk
Portfolio risk
/Concentration risk
Interest Rate risk Infrastructure risk
Settlement risk Forex rate risk Model risk
Equity price risk Human risk
Liquidity risk

12. But under ALM risks that are typically
managed are….
Will now be discussed in detail
Interest
Rate
Risk
Currency
Risk
Liquidity
Risk

13. Liquidity Risk
 Liquidity risk arises from funding of long term assets by short term
liabilities, thus making the liabilities subject to refinancing
• Arises due to unanticipated withdrawals of
the deposits from wholesale or retail clients
Funding
risk
• It arises when an asset turns into a NPA.
So, the expected cash flows are no longer
available to the bank.
Time risk
• Due to crystallisation of contingent
liabilities and unable to undertake
profitable business opportunities when
available.
Call Risk

14. Liquidity Risk Management
 Bank’s liquidity management is the process of generating
funds to meet contractual or relationship obligations at
reasonable prices at all times
 Liquidity Management is the ability of bank to ensure that its
liabilities are met as they become due
 Liquidity positions of bank should be measured on an ongoing
basis
 A standard tool for measuring and managing net funding
requirements, is the use of maturity ladder and calculation of
cumulative surplus or deficit of funds as selected maturity
dates is adopted

15. Statement of Structural Liquidity
All Assets & Liabilities to be reported as per
their maturity profile into 8 maturity Buckets:
i. 1 to 14 days
ii. 15 to 28 days
iii. 29 days and up to 3 months
iv. Over 3 months and up to 6 months
v. Over 6 months and up to 1 year
vi. Over 1 year and up to 3 years
vii. Over 3 years and up to 5 years
viii. Over 5 years

16. Statement of structural liquidity
 Places 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
 Shows the structure as of a particular date
 Banks can fix higher tolerance level for other maturity buckets.

17. An Example of Structural Liquidity Statement
1-14Days
15-28
Days
30 Days-
3 Month
3 Mths -
6 Mths
6 Mths -
1Year
1Year - 3
Years
3 Years -
5 Years
Over 5
Years Total
Capital 200 200
Liab-fixed Int 300 200 200 600 600 300 200 200 2600
Liab-floating Int 350 400 350 450 500 450 450 450 3400
Others 50 50 0 200 300
Total outflow 700 650 550 1050 1100 750 650 1050 6500
Investments 200 150 250 250 300 100 350 900 2500
Loans-fixed Int 50 50 0 100 150 50 100 100 600
Loans - floating 200 150 200 150 150 150 50 50 1100
Loans BPLR Linked 100 150 200 500 350 500 100 100 2000
Others 50 50 0 0 0 0 0 200 300
Total Inflow 600 550 650 1000 950 800 600 1350 6500
Gap -100 -100 100 -50 -150 50 -50 300 0
Cumulative Gap -100 -200 -100 -150 -300 -250 -300 0 0
Gap % to Total Outflow-14.29 -15.38 18.18 -4.76 -13.64 6.67 -7.69 28.57

18. Addressing the mismatches
 Mismatches can be positive or negative
 Positive Mismatch: M.A.>M.L. and Negative Mismatch M.L.>M.A.
 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.

19. Currency Risk
 The increased capital flows from different nations following deregulation
have contributed to increase in the volume of transactions
 Dealing in different currencies brings opportunities as well as risk
 To prevent this banks have been setting up overnight limits and
undertaking active day time trading
 Value at Risk approach to be used to measure the risk associated with
forward exposures. Value at Risk estimates probability of portfolio losses
based on the statistical analysis of historical price trends and volatilities.

20. 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

21. Sources of Interest Rate Risk
Interest
Rate
Risk
Basis
Re-pricing
Yield
Options

22.  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
foreclosure of loans that earned a good spread.

23. Risk Measurement Techniques
Various techniques for measuring exposure of
banks to interest rate risks
 Maturity Gap Analysis
 Duration
 Simulation
 Value at Risk

24. Maturity gap method (IRS)
THREE OPTIONS:
 A) Rate Sensitive Assets>Rate Sensitive
Liabilities= Positive Gap
 B) Rate Sensitive Assets<Rate Sensitive
Liabilities = Negative Gap
 C) Rate Sensitive Assets=Rate Sensitive
Liabilities = Zero Gap

25. Gap Analysis
 Simple maturity/re-pricing Schedules can be used to generate
simple indicators of interest rate risk sensitivity of both
earnings and economic value to changing interest rates
- If a negative gap occurs (RSA<RSL) in given time band, an
increase in market interest rates could cause a decline in NII
- conversely, a positive gap (RSA>RSL) in a given time band,
an decrease in market interest rates could cause a decline in
NII
 The basic weakness with this model is that this method takes
into account only the book value of assets and liabilities and
hence ignores their market value.

26.  It basically refers to the average life of the asset or the
liability
 It is the weighted average time to maturity of all the preset
values of cash flows
 The larger the value of the duration, the more sensitive is the
price of that asset or liability to changes in interest rates
 As per the above equation, the bank will be immunized from
interest rate risk if the duration gap between assets and the
liabilities is zero.
Duration Analysis

27. Simulation
 Basically simulation models utilize computer power
to provide what if scenarios, for example: What if:
 The absolute level of interest rates shift
 Marketing plans are under-or-over achieved
 Margins achieved in the past are not sustained/improved
 Bad debt and prepayment levels change in different interest
rate scenarios
 There are changes in the funding mix e.g.: an increasing
reliance on short-term funds for balance sheet growth
 This dynamic capability adds value to this method
and improves the quality of information available to
the management

28. Value at Risk (VaR)
 Refers to the maximum expected loss that a bank can suffer in
market value or income:
 Over a given time horizon,
 Under normal market conditions,
 At a given level or certainty
 It enables the calculation of market risk of a portfolio for which
no historical data exists. VaR serves as Information Reporting
to stakeholders
 It enables one to calculate the net worth of the organization at
any particular point of time so that it is possible to focus on
long-term risk implications of decisions that have already been
taken or that are going to be taken

29. Thank You!!!