Asset Liability Management in

Banks

Components of a Bank Balance Sheet

Liabilities

Assets

1.
2.
3.
4.
5.

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

Capital
Reserve & Surplus
Deposits
Borrowings
Other Liabilities

Banks profit and loss account

A banks profit & Loss Account has the
following components:
I.

II.

Income: This includes Interest Income

and Other Income.
Expenses: This includes Interest
Expended, Operating Expenses and
Provisions & contingencies.

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.

Evolution of ALM

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

Asset Management

Asset Management: the attempt to earn the

highest possible return on assets while
minimizing the risk.
1.
2.
3.
4.

Get borrowers with low default risk, paying high

interest rates
Buy securities with high return, low risk
Diversified portfolio
Manage liquidity

Asset Management - Credit Risk:

Overcoming Adverse Selection and Moral Hazard

Screening and information collection

Specialization in lending (e.g. energy

sector)

Diversification - by industry and

geography

Monitoring and enforcement of

restrictive covenants

Long-term customer relationships

Collateral and compensating balances

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

3 tools used by banks for ALM

ALM information systems

ALM Organization
ALM Process

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 also help banks in

accessing data.

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

ALM Organisation

Board should have overall responsibility for management of risk

ALCO

Board should decide risk management policy and procedure, set

prudential limits, auditing, reporting and review mechanism in respect of
liquidity, interest rate and forex risk
Consisiting of banks senior management including CEO
Responsible for adherence to the polices and limits set by Board
Responsible for deciding business strategies (on asset liability side) in
line with banks business and risk objectives

ALM Support Group

Consisting of operating staff

Responsible for analysing, monitoring and reporting risk profiles to ALCO
Prepare forecasts showing effects of various possible changes in market
conditions affecting balance sheet and suggesting action to adhere to
banks internal limits

4/27/15

ALM Organisation

(Contd.)

ALCO decision making unit responsible for

Balance Sheet planning from risk-return perspective which includes

management of liquidity, interest rate and forex risks
Pricing of deposits and advances, desired maturity profile etc.
Monitoring the risk levels of the bank
Review of the results and progress of implementation of decisions made
in previous meeting
Future business strategies based on banks current view on interest rates
To decide on source and mix of liabilities or sale of assets
To develop future direction of interest rate movements
To decide on funding mix between fixed and floating rate funds,
wholesale vs. retails deposits, short term vs. long term deposits etc.

4/27/15

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

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
Portfolio risk
/Concentration risk
Settlement risk

Commodity risk

Process risk

Interest Rate risk

Infrastructure risk

Forex rate risk

Model risk

Equity price risk

Human risk

Liquidity risk

But under ALM risks that are typically managed

are.

Liquidity
Risk
Currency
Risk

Intere
st
Rate
Risk

Will now be discussed in detail

Liquidity Risk

Liquidity risk arises from funding of long term assets by

short term liabilities, thus making the liabilities subject to
refinancing

Funding
risk

Arises due to unanticipated

withdrawals of the deposits from
wholesale or retail clients

Time
risk

It arises when an asset turns into a

NPA. So, the expected cash flows
are no longer available to the bank.

Call
Risk

Due to crystallisation of contingent

liabilities and unable to undertake
profitable business opportunities
when available.

Liquidity Risk Management

Banks 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

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

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.

An Example of Structural Liquidity Statement

15-28
1-14Days Days

Capital
Liab-fixed Int
Liab-floating Int
Others
Total outflow
Investments
Loans-fixed Int
Loans - floating

300 200
350 400
50 50
700 650
200 150
50 50
200 150
Loans BPLR Linked
100 150
Others
50 50
Total Inflow
600 550
Gap
-100 -100
Cumulative Gap -100 -200
-14.29 -15.38
Gap % to Total Outflow

30 Days- 3 Mths - 6 Mths - 1Year - 3 3 Years - Over 5

3 Month 6 Mths
1Year
Years
5 Years Years

200 600 600 300 200

350 450 500 450 450
0
550 1050 1100 750 650
250 250 300 100 350
0 100 150 50 100
200 150 150 150 50
200 500 350 500 100
0
0
0
0
0
650 1000 950 800 600
100 -50 -150 50 -50
-100 -150 -300 -250 -300
18.18

-4.76

-13.64

6.67

-7.69

200
200
450
200
1050
900
100
50
100
200
1350
300
0
28.57

Total

200
2600
3400
300
6500
2500
600
1100
2000
300
6500
0
0

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.

Interest Rate Risk

Interest Rate risk is the exposure of a banks 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 banks
earnings and capital base

Changes in interest rates also affect the underlying value

of the banks 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

Risk Measurement Techniques

Various techniques for measuring exposure
of banks to interest rate risks
Maturity Gap Analysis
Duration
Simulation
Value at Risk

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

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.

Duration Analysis

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.

Measuring Risk to Net Interest Income (NII)

Gap schedules can provide an estimate of
changes in banks net interest income given
changes in interest rates.
The gap for particular time band could be
multiplied by a hypothetical change in interest
rate to obtain an approximate change in net
interest income. The formula to translate gaps
into the amount of net interest income at risk,
measuring exposure over several periods, is:
(Periodic gap) x (change in rate) x (time
over which the periodic gap is in effect) =
change in NII

Reasons for Interest Rate Risk

On account of asset transformation

Many deposits are used for one big loan

Periodical review of assets and liabilities

Due to mismatches between maturity /
repricing dates as well as maturity
amounts between assets and liabilities
Depositors and borrowers may pre-close
their accounts

College of
Agricultural

4/27/15

Measurement of Risks (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

In a dynamic simulation approach, the

simulation builds in more detailed
assumptions about the future course of
interest rates and expected changes in a
bank's business activity over that time.

Management of Interest Rate Risk

(contd.)

Each bank to set its prudential limits on

individual gaps with approval of Board
Prudential limits set with respect to bearing
on Total Assets, Earning Assets or Equity
Banks may work out their Earnings at Risk
20-30% of last years NII or NIM

College of
Agricultural

4/27/15

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

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.

Foreign Exchange Exposure and Risk and Risk Management

Exposure refers to the degree to which a bank is

affected by exchange rate changes.
Exchange rate risk is defined as the variability of a
firms value due to uncertain changes in the rate of
exchange.
Managing Foreign Exposure with the concept of Risk
Management is called Hedging.
Entering into an offsetting currency position
so whatever is lost/gained on the original
currency exposure is exactly offset by a
corresponding currency gain/loss on the
currency hedge.

Insuring Against Foreign Exchange Risk

The

foreign exchange market can be used

to provide insurance to protect against
foreign exchange risk (the possibility that
unpredicted changes in future exchange
rates will have adverse consequences for
the firm)
A firm that insures itself against foreign
exchange risk is hedging

Hedging
Hedging is insurance. The purpose of
hedging is to reduce or eliminate risks, not
to make profits.
Objectives
Minimize translation exposure.
Minimize transaction exposure.
Minimize economic exposure.
Minimize quarter-to-quarter earnings fluctuations
arising from exchange rate changes.
Minimize foreign exchange risk management costs.
Avoid surprises.

What are Options?

Contracts that give the holder the option to
buy/sell specified quantity of the
underlying assets at a particular price on
or before a specified time period.
The word option means that the holder
has the right but not the obligation to
buy/sell underlying assets.

Types of Options
Options are of two types call and put.
Call option give the buyer the right but not
the obligation to buy a given quantity of
the underlying asset, at a given price on or
before a particular date by paying a
premium.
Puts give to seller the the right, but not
obligation to sell a given quantity of the
underlying asset at a given price on or
before a particular date by paying a
premium.

Risk Monitoring.
Risk monitoring processes are established
to evaluate the performance of banks risk
strategies/policies and procedures in
achieving overall goals.
Reporting of risk measures should be
regular and should clearly compare current
exposures to policy limits. Further past
forecast or risk estimates should be
compared with actual results to identify
any shortcomings in risk measurement
techniques.

Risk Control
Banks internal control structure ensures
the effectiveness of process relating to
market risk management.
Persons responsible for risk monitoring and
control procedures should be independent
of the functions they review.
Key elements of internal control process
include internal audit and review and an
effective risk limit structure.