ALCO primarily employs these three strategies in order to achieve the objectives referred

above.

• Spread Management

• Gap Management

• Interest rate sensitivity analysis

All the risks that the institution is exposed to, are mainly countered using above mentioned

approaches.

Spread Management

Spread can be defined as the difference between interest earned on deployment of finan-

cial resources and interest earned on required financial resources. Spread is also known

as interest margin.

One of the principle on which bank runs is profitability. To achieve profitability and to main-

tain profitability once achieved in the globalised and extremely competitive economic envi-

ronment is a big challenge. Targets of profitability directly points towards maximising

spread through various strategies.

Banks are exposed to interest rate risk. Exposure of banks in some asset classes, which

perform cyclically and are not stable income generators, leads banks to have exposure to

cyclical rates. Reducing it helps achieving stabilisation in earnings in long term.

In the era of liberalised economies, banks are exposed to many uncertainties. These un-

certainties might cause unexpected change in rate change which ultimately would affect

the profitability. So, predicting these kinds of rate changes by employing various statistical

tools available would help the bank prepare shield against these risky eventualities.

Banks also need to assess the default risk on deployed financial resources and accord-

ingly should manage its further investment ensuring good chances of profitability. This

way, probable benefits will balance probable losses and would ensure profitability.

In search of growth, strategies should not aim to achieve extreme targets. Rather, Gradual

improvement in profitability should be targeted to ensured steady and controlled growth.

Gap Management

Gap is essentially the difference between Rate sensitive assets and Rate sensitive liabili-

ties.

Assets and liabilities which gets impacted by the change in the interest rate are defined as

Rate Sensitive Assets (RSA) & Rate Sensitive Liabilities (RSL) respectively.

Gaps are identified in time buckets which are as under:

1. 1 - 28 days

2. 29 days & upto 3 months

3. Over 3 months & upto 6 months

4. Over 6 months & upto 1 Year

5. Over 1 year & upto 3 years

6. Over 3 years & upto 5 years

7. Over 5 years

8. Non-sensitive

The difference between RSA & RSL is calculated for each time bucket.

Positive Gap: RSA > RSL

Negative Gap: RSL > RSA

As earlier discussed, the aim is to reduce risk and improve profitability. So, reports are

made as to the bank or FI is in a stance to benefit from increasing interest rates by having

Positive Gap (RSA > RSL) or it is in a stance to benefit from decreasing/falling interest

rates by having a Negative Gap (RSL >RSA).

Bases on the view of the potential change in interest rates, banks and financial institutions

aims/sets limits on interest rate gaps in all the time buckets.

Once the benchmark is set, banks which are better equipped to assess rolls-in, rolls-out,

behavioural pattern of various assets and liabilities, classify them in various time buckets

on approval of ALCO

And thus comes the analysis of interest rate sensitivity.

Interest Rate Sensitivity

Interest rate sensitivity may be thought of as an extension to Gap Analysis.

As the name itself suggests, it calculates impact of change in interest rates on the spread

of the bank and ultimately on overall earnings of the bank.

First of all, variable interest rate components of the balance sheet are needed to be sepa-

rated from fixed interest rate components. Because, change in interest rates would affect

the variable ones and not the fixed one.

Next step in this is to make assumptions regarding rise and fall in interest rates. These as-

sumptions need to be realistic based on macroeconomics environment and stance of the

central bank on it.

Moving forward, the next step would be to test impact of assumed changes in the compo-

sition of the portfolio. Change in the size/volume of the portfolio is also needs to be deter-

mined again increase and decrease of interest rates.

To be better able to do the interest rate sensitivity analysis, classification of assets and lia-

bilities as long term or short term is essential as it provides better view as to more of the

bank’s assets are interest rate sensitive or not.

The table below summarises, how for a Gap position, change in interest rate s lead to

change in Net Interest Income (NII).

Gap Position Change in Interest Rate

Change in Interest Income

Change in Interest Expenses

Change in Net In-terest Income