Assets Liability Management

It is a dynamic process of Planning, Organizing & Controlling of Assets & Liabilities- their volumes, mixes, maturities, yields and costs in order to maintain liquidity and NII.

Significance of ALM

• Volatility

• Product Innovations & Complexities

• Regulatory Environment

• Management Recognition

Purpose & Objective of ALMAn 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 ration.

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

RBI DIRECTIVES• Issued draft guidelines on 10th Sept’98.

• Final guidelines issued on 10th Feb’99 for implementation of ALM w.e.f. 01.04.99.

• To begin with 60% of asset &liabilities will be covered; 100% from 01.04.2000.

• Initially Gap Analysis to be applied in the first stage of implementation.

• Disclosure to Balance Sheet on maturity pattern on Deposits, Borrowings, Investment & Advances w.e.f. 31.03.01

INTRODUCTION

• Asset liability management (ALM) – interest rate risk: The interest-rate risk arises

from the possibility that profits will change if interest rates change.

– liquidity risk: The liquidity risk arises from the possibility of losses due in the bank having insufficient cash on hand to pay customers.

– Both risks are due to the difference between the bank's assets and liabilities.

INTRODUCTION• The best illustration of ALM : U.S. savings and

loan (S&L) crisis – Savings and loan banks: retail banks, receive retail

deposits and make retail loans– For many years, interest rates stable. Deposits for

around 4% (floating rate), and they lent 30-year mortgages paying about 8% at fixed rates.

– Then in the 1980s, the Federal Reserve allowed interest rates to float. Short-term interest rates rose to 16%.

– Many deposit customers withdrew their funds or demanded the higher rates

– The rate of mortgages is fixed with 8%, however the rate of deposits is floating and the banks have to pay 16% to deposit customers

– This causes the banks a lot of loss and go to bankrupt

INTRODUCTION• Several keys of the above example

– The rate of deposit is floating and the rate of mortgage is fixed

– The deposit (loan) is more (less) sensitive to interest rate

– Or, the deposits (one kind of banks’ liabilities) is rate-sensitive and the mortgage (one kind of banks’ assets) is rate-insensitive.

– The interest rate risks will rise when the RSL (rate-sensitive liabilities) is not equal to RSA (rate-sensitive assets)

– How to evaluate the size to rate sensitivity?

Duration of First

National Bank's

Assets and Liabilities

Duration in year (or in %)

0.4 X (5/100)

Review: Duration Analysis for Bonds

10

Duration Gap

Analysis

%P DUR i

i 5%, from 10% to 15%

Asset Value = %P Assets

= 2.7 .05 $100m

= $13.5m

Liability Value = %P Liabilities

= 1.03 .05 $95m

= $4.9m

NW = $13.5m ($4.9m) = $8.6m

DURgap = DURa [L/A DURl]

= 2.7 [(95/100) 1.03]

= 1.72

%NW = DURgap i

= 1.72 .05

= .086 = 8.6%

NW = .086 $100m

= $8.6m

Example of Finance Company

Duration Analysis

If i 5%

Duration Gap Analysis

DURgap = DURa [L/A DURl]

= 1.16 [90/100 2.77] = 1.33 years

% NW = DURgap X i

= (1.33) .05

= .0665 = 6.5%

Managing Interest-Rate Risk

• Strategies for Managing Interest-Rate Risk

– In example above, shorten duration of bank assets or lengthen duration of bank liabilities

– To completely immunize net worth from interest-rate risk, set DURgap = 0

Reduce DURa = 0.98 DURgap = 0.98 [(95/100) 1.03] = 0

Raise DURl = 2.80 DURgap = 2.7 [(95/100) 2.80] = 0

INTRODUCTION• liquidity risks

– This is the challenge of ensuring that the bank has sufficient liquid assets available to meet all its required payments, including the possibility of a "run on the bank."

– A run on the bank occurs when deposit customers lose confidence in a bank's creditworthiness and rush to the bank to take out their savings before the bank collapse

– If the bank does not have enough liquid assets available, what will happen?

– In most developed countries, this risk is greatly reduced by deposit insurance backed by the government. In India, DICGC guarantees that retail depositors will be compensated up to Rs.100,000 if their bank fails

INTRODUCTION

• By modeling and understanding ALM risks:– banks seek to minimize the risks and know

how much to charge customers to cover the capital consumed by the risks.

– Another important aspect of ALM is determining the fair, risk-minimizing interest rates that should be charged internally between the bank's business units when the lend funds to each other.

SOURCES OF INTEREST-RATE RISK• Many banks in emerging-market countries have a

large portion of their balance sheets in the form of loans denominated in U.S. dollars– Both the structural interest rate and the structural FX

positions are managed in the ALM framework

• The primary cause of structural interest-rate risk is:– customers want both long-term loans and quick access

to any deposits– This leaves banks in a position in which they are

receiving long-term, fixed-rate interest payments from borrowers and paying short-term, floating-rate interest to depositor.

SOURCES OF INTEREST-RATE RISK

Figure 12-1a illustrates a possible scenario

Figure 12-1b shows the net interest income (NII), i.e., interest income minus interest costs

SOURCES OF INTEREST-RATE RISK

Figure 12-1c: non interest expenses are partially floating

Figure 12-1d : the result is the net earnings for the bank

SOURCES OF INTEREST-RATE RISK

• The measurement of ALM risks is made more difficult than the management of a simple bond portfolio. – because of the indeterminate maturities of assets

and liabilities.– The indeterminate maturity describes the

uncertainty as to when customers will make or ask for payments

– We will discuss the above behaviors in detail in the following discussion

– Uncertain prepayment and withdraw behaviors

SOURCES OF INTEREST-RATE RISK

• What are the differences between the risk of the structural interest-rate position and the market risk of the trading room?– In the trading room, all transactions are clearly

structured. With bonds, the maturity is known, and the term is fixed by the contract underlying the security. With options, the expectation is that every option will be exercised to maximize the advantage to the holder

– In contrast, ALM products such as mortgages and deposits have many implicit or embedded options that make the values dependent not only on market rates, but also on customer behavior. For example, customers have the option to withdraw their deposit accounts whenever they wish, or to prepay a mortgage early if they find a cheaper mortgage elsewhere.

Liquidity Management

Bank’s liquidity management is the process of generating funds to meet contractual or relationship obligations at reasonable prices at all times.

New loan demands, existing commitments, and deposit withdrawals are the basic contractual or relationship obligations that a bank must meet.

Adequacy of liquidity position for a bank

Analysis of following factors throw light on a bank’s adequacy of liquidity position:

a. Historical Funding requirementb. Current liquidity positionc. Anticipated future funding needsd. Sources of fundse. Options for reducing funding needsf. Present and anticipated asset qualityg. Present and future earning capacity andh. Present and planned capital position

Funding Avenues

To satisfy funding needs, a bank must perform one or a combination of the following:

a. Dispose off liquid assetsb. Increase short term borrowingsc. Decrease holding of less liquid assetsd. Increase liability of a term naturee. Increase Capital funds

Types of Liquidity Risk

• Liquidity Exposure can stem from both internally and externally.

• External liquidity risks can be geographic, systemic or instrument specific.

• Internal liquidity risk relates largely to perceptions of an institution in its various markets: local, regional, national or international

Other categories of liquidity risk

• Funding Risk- Need to replace net outflows due to unanticipated withdrawals/non-

renewal• Time Risk

- Need to compensate for non-receipt of expected inflows of funds

• Call Risk- Crystallization of contingent liability

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 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 200Liab-fixed Int 300 200 200 600 600 300 200 200 2600Liab-floating Int 350 400 350 450 500 450 450 450 3400Others 50 50 0 200 300Total outflow 700 650 550 1050 1100 750 650 1050 6500Investments 200 150 250 250 300 100 350 900 2500Loans-fixed Int 50 50 0 100 150 50 100 100 600Loans - floating 200 150 200 150 150 150 50 50 1100Loans BPLR Linked 100 150 200 500 350 500 100 100 2000Others 50 50 0 0 0 0 0 200 300Total Inflow 600 550 650 1000 950 800 600 1350 6500Gap -100 -100 100 -50 -150 50 -50 300 0Cumulative Gap -100 -200 -100 -150 -300 -250 -300 0 0Gap % to Total Outflow-14.29 -15.38 18.18 -4.76 -13.64 6.67 -7.69 28.57

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.

STRATEGIES…• To meet the mismatch in any maturity

bucket, the bank has to look into taking deposit and invest it suitably so as to mature in time bucket with negative mismatch.

• The bank can raise fresh deposits of Rs 300 crore over 5 years maturities and invest it in securities of 1-29 days of Rs 200 crores and rest matching with other out flows.

Maturity Pattern of Select Assets & Liabilities of A Bank

Liability/Assets Rupees(In Cr)

In Percentage

I. Depositsa. Up to 1 yearb. Over 1 yr to 3 yrsc. Over 3 yrs to 5 yrsd. Over 5 years

1520080006700230270

10052.6344.08 1.51 1.78

II. Borrowingsa. Up to 1 yearb. Over 1 yr to 3 yrsc. Over 3 yrs to 5 yrsd. Over 5 years

450180 00150120

10040.00 0.0033.3326.67

III. Loans & Advancesa. Up to 1 yearb. Over 1 yr to 3 yrsc. Over 3 yrs to 5 yrsd. Over 5 years

880034003000 4002000

10038.6434.09 4.5522.72

Iv. Investmenta. Up to 1 yearb. Over 1 yr to 3 yrsc. Over 3 yrs to 5 yrsd. Over 5 years

58001300 300 9003300

10022.41 5.1715.5256.90

STATEMENT OF INTEREST RATE SENSITIVITY• Generated by grouping RSA,RSL & OFF-

Balance sheet items in to various (8)time buckets.

RSA:• MONEY AT CALL• ADVANCES ( BPLR LINKED )• INVESTMENTRSL• DEPOSITS EXCLUDING CD• BORROWINGS

MATURITY GAP METHOD(IRS)

• THREE OPTIONS:

• A) RSA>RSL= Positive Gap

• B) RSL>RSA= Negative Gap

• C) RSL=RSA= Zero Gap

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.

Interest Rate Risk Management

• 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

• Interest rate risk refers to volatility in Net Interest Income (NII) or variations in Net Interest Margin(NIM).

• Therefore,an effective risk management process that maintains interest rate risk within prudent levels is essential to safety and soundness of the bank.

Sources of Interest Rate Risk

• Interest rate risk mainly arises from:– Gap Risk– Basis Risk– Net Interest Position Risk– Embedded Option Risk– Yield Curve Risk– Price Risk– Reinvestment Risk

Measurement of Interest Rate Risk

• 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.

Measurement of Interest Rate Risk

• Duration Analysis: Duration is a measure of the percentage change in the economic value of a position that occur given a small change in level of interest rate.