ALM PPT

Asset and Liability Asset and Liability ManagementManagement

Road mapRoad map MeaningMeaning History & evolutionHistory & evolution ALM interest rate risk managementALM interest rate risk management ExamplesExamples Importance of ALMImportance of ALM Scope of ALMScope of ALM BenefitsBenefits Who Can Benefit from ALM?Who Can Benefit from ALM? ProcessProcess Four pillarsFour pillars Risk & its typesRisk & its types Liquidity risk managementLiquidity risk management Interest rate managementInterest rate management Model & techniquesModel & techniques conclusionconclusion

MeaningMeaning

““Asset Liability Management is the on-going process of Asset Liability Management is the on-going process of formulating, implementing, monitoring, and revising strategies formulating, implementing, monitoring, and revising strategies related to assets and liabilities in an attempt to achieve related to assets and liabilities in an attempt to achieve financial objectives for a given set of risk tolerances and financial objectives for a given set of risk tolerances and constraints."constraints."

In BankingIn Banking

“ “ the practice of managingthe practice of managing risks risks that arise due to mismatches that arise due to mismatches between the assets and liabilities (debts and assets) of the between the assets and liabilities (debts and assets) of the bank. bank.

Structural interest rate, forex, equity and liquidity risks are Structural interest rate, forex, equity and liquidity risks are managed and supervised by the Group’s Asset and Liability managed and supervised by the Group’s Asset and Liability Management function (or ALM )”Management function (or ALM )”

ALM covers the management of the entire balance sheet of a ALM covers the management of the entire balance sheet of a bankbank

first step in the first step in the long-term strategic planning processlong-term strategic planning process

various aspects of balance sheet management deal various aspects of balance sheet management deal with planning as well as with planning as well as

direction and control of the levels, changes and mixes of assets, liabilities, and capital direction and control of the levels, changes and mixes of assets, liabilities, and capital

The initial focus of the ALM function would be to The initial focus of the ALM function would be to enforce the risk management enforce the risk management

discipline discipline viz. managing business after assessing the risks involved viz. managing business after assessing the risks involved

Provides banks with protection that makes their risk acceptableProvides banks with protection that makes their risk acceptable enables institutions to measure and monitor risk, and provide suitable strategies enables institutions to measure and monitor risk, and provide suitable strategies

for their managementfor their management

credit riskcredit risk

interest risk interest risk

foreign exchange risk, foreign exchange risk,

equity / commodity price riskequity / commodity price risk

operational risksoperational risks

liquidity risk liquidity risk

ALM interest rate risk ALM interest rate risk managementmanagement

The ALM interest rate risk management is The ALM interest rate risk management is split into two categories: split into two categories:

1. 1. Short-term ALM (up to 2 years)Short-term ALM (up to 2 years), which , which is delegated and captured by the market is delegated and captured by the market risk management driven approach (VaR risk management driven approach (VaR limits, sensitivity limits, triggers, stop loss, limits, sensitivity limits, triggers, stop loss, daily follow-u); daily follow-u);

2. 2. Long-term ALMLong-term ALM, which is not delegated , which is not delegated and subject to a dedicated follow-up by and subject to a dedicated follow-up by the ALCO Group, which meets on a the ALCO Group, which meets on a monthly basis monthly basis

Prior To 1970sPrior To 1970s

Banks used Banks used accrual system of accountingaccrual system of accounting Focus on Asset Management Only Focus on Asset Management Only Wrong notion among bankersWrong notion among bankers RBI restrictionsRBI restrictions

Prior To 1970sPrior To 1970s

Banks used Banks used accrual system of accountingaccrual system of accounting

e-ge-g - - a bank that borrows 1 Crore (100 Lakhs) at 6 % for a year and a bank that borrows 1 Crore (100 Lakhs) at 6 % for a year and lends the same money at 7 % to a highly rated borrower for 5 years. lends the same money at 7 % to a highly rated borrower for 5 years. The net transaction appears profitable-the bank is earning a 100 basis The net transaction appears profitable-the bank is earning a 100 basis point spread - but it entails considerable risk. At the end of a year, the point spread - but it entails considerable risk. At the end of a year, the bank will have to find new financing for the loan, which will have 4 bank will have to find new financing for the loan, which will have 4 more years before it matures. If interest rates have risen, the bank may more years before it matures. If interest rates have risen, the bank may have to pay a higher rate of interest on the new financing than the have to pay a higher rate of interest on the new financing than the fixed 7 % it is earning on its loan. Suppose, at the end of a year, an fixed 7 % it is earning on its loan. Suppose, at the end of a year, an applicable 4-year interest rate is 8 %. The bank is in serious trouble. It applicable 4-year interest rate is 8 %. The bank is in serious trouble. It is going to earn 7 % on its loan but would have to pay 8 % on its is going to earn 7 % on its loan but would have to pay 8 % on its financing. Accrual accounting does not recognize this problem. Based financing. Accrual accounting does not recognize this problem. Based upon accrual accounting, the bank would earn Rs 100,000 in the first upon accrual accounting, the bank would earn Rs 100,000 in the first year although in the preceding years it is going to incur a loss year although in the preceding years it is going to incur a loss

CONT…CONT…

Focus on Asset Management Only coz:Focus on Asset Management Only coz: abundance of funds in banks (demand & savings abundance of funds in banks (demand & savings

deposits)deposits) low cost of deposits low cost of deposits

Wrong notion among bankersWrong notion among bankers

- that their banks already practice - that their banks already practice

- ALM is a system of matching cash inflows - ALM is a system of matching cash inflows and outflows, and thus of liquidity and outflows, and thus of liquidity management. management.

RBI restrictionsRBI restrictions - Spreads between the deposit and Spreads between the deposit and

lending rates were very wide lending rates were very wide - Spread were uniform among the Spread were uniform among the

commercial banks and were changed commercial banks and were changed only by RBIonly by RBI

- balance sheet was not being managed balance sheet was not being managed by banks themselves by banks themselves

SO, banks had to develop mechanisms by SO, banks had to develop mechanisms by which they could make efficient use of which they could make efficient use of these funds these funds

After 1970sAfter 1970sWith the onset of liberalization, Indian banks With the onset of liberalization, Indian banks

are now more exposed toare now more exposed touncertainty and to global competition. This uncertainty and to global competition. This makes it imperative to have proper ALM makes it imperative to have proper ALM

systems in place. systems in place.

The Banks started to concentrateThe Banks started to concentrate on ALM on ALM COZ: COZ:

Decline in availability of low cost fundsDecline in availability of low cost funds volatile interest rates volatile interest rates a severe recession damaging several economies a severe recession damaging several economies suffered staggering losses because the firms used accrual suffered staggering losses because the firms used accrual

accounting accounting small percentage changes in assets or liabilities can translate small percentage changes in assets or liabilities can translate

into large percentage changes in capital. into large percentage changes in capital.

The induction of credit risk into the issue of determining adequacy of The induction of credit risk into the issue of determining adequacy of

bank capital In later 1980s bank capital In later 1980s

freedom to manage their balance sheets freedom to manage their balance sheets

RBI's monetary and credit policy of October 1997RBI's monetary and credit policy of October 1997 recommends, an recommends, an adequate system of ALM to incorporate comprehensive risk adequate system of ALM to incorporate comprehensive risk management should be introduced in the PSBs management should be introduced in the PSBs

Why asset-liability management is Why asset-liability management is

necessary in the Indian bank context:necessary in the Indian bank context: NIM - efficient management of net interest margin NIM - efficient management of net interest margin To solve inadequate and inefficient management systems To solve inadequate and inefficient management systems maintain exposure to foreign currency fluctuations maintain exposure to foreign currency fluctuations increasing proportion of investments by banks increasing proportion of investments by banks exposure to interest rate volatilityexposure to interest rate volatility

Scope of ALMScope of ALMManagement of market risks Management of market risks - - Interest Rate RiskInterest Rate Risk

Trading risk management Trading risk management - - e.g. Airlines hedging of fuel prices or manufacturers' hedging of e.g. Airlines hedging of fuel prices or manufacturers' hedging of

steel prices are often presented as ALM.steel prices are often presented as ALM.

Non-trading risk management Non-trading risk management - - foreign exchange risk foreign exchange risk Other riskOther risk

CorporationsCorporationsinterest-rate exposuresinterest-rate exposuresLiquidity risk managementLiquidity risk managementforeign exchange risk foreign exchange risk commodities risks commodities risks

Funding and capital planningFunding and capital planning

Profit planning and growth projectionProfit planning and growth projection

BenefitsBenefits

Any organization can receive the following Any organization can receive the following benefits from ALM:benefits from ALM:

1.1. • • Improved regulatory complianceImproved regulatory compliance

2.2. • • Enhanced corporate governanceEnhanced corporate governance

3.3. • • Increased shareholder returnIncreased shareholder return

4.4. • • Reduced earnings volatilityReduced earnings volatility

5.5. • • Enhanced cash flow and fair market value forecastingEnhanced cash flow and fair market value forecasting

6.6. • • Improved asset and liability alignmentImproved asset and liability alignment

Who Can Benefit from ALM?Who Can Benefit from ALM?Companies that can benefit from ALM typically show one or more of the following Companies that can benefit from ALM typically show one or more of the following

Characteristics:Characteristics:

1.1. • • Regulatory requirements mandating an independent model assessmentRegulatory requirements mandating an independent model assessment2.2. • • Volatile earnings or narrow profit marginsVolatile earnings or narrow profit margins3.3. • • Inadequate or static risk identification tools (e.g., TB-13A, static gap)Inadequate or static risk identification tools (e.g., TB-13A, static gap)4.4. • • Manual or proprietary modelsManual or proprietary models5.5. • • Limited assumption generation or validation capabilitiesLimited assumption generation or validation capabilities6.6. • • Sizeable interest rate exposureSizeable interest rate exposure7.7. • • Limited interest rate hedging strategiesLimited interest rate hedging strategies8.8. • • Significant cash flow mismatchesSignificant cash flow mismatches

The ALM process rests on Four The ALM process rests on Four pillarspillars

1)1) Developing a better understanding of ALM concepts Developing a better understanding of ALM concepts

2)2) Introducing an ALM information systemsIntroducing an ALM information systems

=> Management Information System=> Management Information System

Information availability, accuracy, adequacy and expediencyInformation availability, accuracy, adequacy and expediency

3)3) Setting up ALM decision-making processes (ALM organization)Setting up ALM decision-making processes (ALM organization)

=> Structure and responsibilities=> Structure and responsibilities

=> Level of top management involvement=> Level of top management involvement

4)4) ALM processALM process

=> Risk parameters=> Risk parameters

=> Risk identification=> Risk identification

=> Risk measurement=> Risk measurement

=> Risk management=> Risk management

=> Risk policies and tolerance Levels.=> Risk policies and tolerance Levels.

ALM information systemsALM information systems

Information is the key to the ALM process.Information is the key to the ALM process.

Considering the large network of branches Considering the large network of branches and the lack of an adequate system to collect information and the lack of an adequate system to collect information

required for ALM required for ALM which analyses information on the basis of residual maturity and which analyses information on the basis of residual maturity and

behavioural patternbehavioural pattern it will take time for banks in the present state to get the requisite it will take time for banks in the present state to get the requisite

information. information.

The problem of ALM needs to be addressed by following an The problem of ALM needs to be addressed by following an ABC approachABC approach

i.e. analysing the behaviour of asset and liability products in i.e. analysing the behaviour of asset and liability products in the top branches accounting for significant businessthe top branches accounting for significant business

and then making rational assumptions about the way in which and then making rational assumptions about the way in which assets and liabilities would behave in other branches.assets and liabilities would behave in other branches.

In respect of foreign exchange, investment. portfolio and In respect of foreign exchange, investment. portfolio and money market operations, in view of the centralised nature of money market operations, in view of the centralised nature of the functions, it would be much easier to collect reliable the functions, it would be much easier to collect reliable information. information.

The data and assumptions can then be refined over time as the The data and assumptions can then be refined over time as the bank management gain experience of conducting business bank management gain experience of conducting business within an ALM framework. within an ALM framework.

The spread of computerisation will also help banks in The spread of computerisation will also help banks in accessing data.accessing data.

ALM organisationALM organisation

The Board The Board The Asset - Liability Committee (ALCO )The Asset - Liability Committee (ALCO ) The ALM desk The ALM desk The ALCO is a decision making UnitThe ALCO is a decision making Unit Composition of ALCO Composition of ALCO Committee of Directors Committee of Directors

Example: Asset-Liability Example: Asset-Liability RiskRiskExhibit 1Exhibit 1

Asset-liability risk is leveraged Asset-liability risk is leveraged by the fact that the values of by the fact that the values of assets and liabilities each assets and liabilities each tend to be greater than the tend to be greater than the value of capital. In this value of capital. In this example, modest fluctuations example, modest fluctuations in values of assets and in values of assets and liabilities result in a 50% liabilities result in a 50% reduction in capital.reduction in capital.

ALM PROCESSALM PROCESS

The scope of ALM function can be described The scope of ALM function can be described as follows:as follows:

LR managementLR management MR Management (including IR Risk)MR Management (including IR Risk) Trading risk managementTrading risk management Funding and capital planningFunding and capital planning Profit planning and growth projectionProfit planning and growth projection

Categories of riskCategories of risk

Credit riskCredit risk Capital riskCapital risk Market riskMarket risk Interest rate riskInterest rate risk MaturityMaturity DurationDuration Dollar durationDollar duration Convexity ( Convexity ( how the duration of a how the duration of a

bond changes as the interest rate bond changes as the interest rate changes. )changes. )

Liquidity riskLiquidity risk

Liquidity Risk Management Liquidity Risk Management

•Measuring and managing liquidity needs are vital activities of commercial banks.

•By assuring a bank's ability to meet its liabilities as they become due, liquidity management can reduce the probability of an adverse situation developing.

The importance of liquidity transcends individual institutions -- liquidity shortfall in one institution can have repercussions on the entire system.

Bank management should measure not only the liquidity positions of banks on an ongoing basis but also examine how liquidity requirements are likely to evolve under crisis scenarios.

Experience shows that assets Commonly considered as liquid like G-SEC could also become illiquid when the market and players are unidirectional.

Therefore liquidity has to be tracked through maturity or cash flow mismatches.

For measuring and managing net funding requirements, the use of - a maturity ladder and - calculation of cumulative surplus or

deficit of funds at selected maturity dates is adopted as a standard tool.

The time buckets given the Statutory Reserve cycle of 14 The time buckets given the Statutory Reserve cycle of 14 days may be distributed as under :days may be distributed as under :

i) 1 to 14 daysi) 1 to 14 days ii) 15 to 28 daysii) 15 to 28 days iii) 29 days and upto 3 monthsiii) 29 days and upto 3 months iv) Over 3 months and upto 6 monthsiv) Over 3 months and upto 6 months v) Over 6 months and upto 12 monthsv) Over 6 months and upto 12 months vi) Over 1 year and upto 2 yearsvi) Over 1 year and upto 2 years vii) Over 2 years and upto 5 yearsvii) Over 2 years and upto 5 years viii) Over 5 yearsviii) Over 5 years

Within each time bucket there could be mismatches Within each time bucket there could be mismatches depending on cash inflows and outflows.depending on cash inflows and outflows.

While the mismatches up to one year would be While the mismatches up to one year would be

relevant since these provide early warning signals of relevant since these provide early warning signals of impending liquidity problems, the main focus should impending liquidity problems, the main focus should be on the short term mismatches viz., 1-14 days be on the short term mismatches viz., 1-14 days and 15-28 days.and 15-28 days.

Banks, however, are expected to monitor their Banks, however, are expected to monitor their

cumulative mismatches (running total) across all cumulative mismatches (running total) across all time buckets by establishing internal prudential time buckets by establishing internal prudential limits with the approval of the Board / Management limits with the approval of the Board / Management Committee.Committee.

The mismatch during 1-14 days and 15-28 days The mismatch during 1-14 days and 15-28 days should not in any case exceed 20% of the cash should not in any case exceed 20% of the cash outflows in each time bucket.outflows in each time bucket.

Cont…Cont…

If a bank in view of its asset -liability profile needs If a bank in view of its asset -liability profile needs

higher tolerance level, it could operate with higher tolerance level, it could operate with

higher limit sanctioned by its Board / higher limit sanctioned by its Board /

Management Committee giving reasons on the Management Committee giving reasons on the

need for such higher limit. need for such higher limit.

A copy of the note approved by Board / A copy of the note approved by Board /

Management Committee may be forwarded to the Management Committee may be forwarded to the

Department of Banking Supervision, RBI. Department of Banking Supervision, RBI.

The discretion to allow a higher The discretion to allow a higher tolerance level is intended for a tolerance level is intended for a temporary period, till the system temporary period, till the system stabilises and the bank is able to stabilises and the bank is able to restructure its asset -liability pattern.restructure its asset -liability pattern.

Cont…Cont…

The Statement of Structural Liquidity The Statement of Structural Liquidity ( Annexure I ) may be prepared by ( Annexure I ) may be prepared by placing all cash inflows and outflows placing all cash inflows and outflows in the maturity ladder according to in the maturity ladder according to the expected timing of cash flows. the expected timing of cash flows.

A maturing liability will be a cash A maturing liability will be a cash outflow while a maturing asset will outflow while a maturing asset will be a cash inflow. be a cash inflow.

It would be necessary to take into It would be necessary to take into account the rupee inflows and account the rupee inflows and outflows on account of forex outflows on account of forex operations including the readily operations including the readily available forex resources ( FCNR (B) available forex resources ( FCNR (B) funds, etc) which can be deployed forfunds, etc) which can be deployed for

augmenting rupee resources. While augmenting rupee resources. While determining the likely cash inflows / determining the likely cash inflows / outflows, banks have to make a outflows, banks have to make a number of assumptions according to number of assumptions according to their asset - liability profilestheir asset - liability profiles

Cont…Cont…

For instance, Indian banks with large For instance, Indian banks with large branch network can (on the stability branch network can (on the stability of their deposit base as most deposits of their deposit base as most deposits are renewed) afford to have larger are renewed) afford to have larger tolerance levels in mismatches if tolerance levels in mismatches if their term deposit base is quite high. their term deposit base is quite high.

While determining the tolerance levels the While determining the tolerance levels the banks may take into account all relevant banks may take into account all relevant factors based on their asset-liability base, factors based on their asset-liability base, nature of business, future strategy etc. nature of business, future strategy etc.

The RBI is interested in ensuring that the The RBI is interested in ensuring that the tolerance levels are determined keeping all tolerance levels are determined keeping all necessary factors in view and further refined necessary factors in view and further refined with experience gained in Liquidity with experience gained in Liquidity ManagementManagement

In order to enable the banks to monitor their short-term liquidity In order to enable the banks to monitor their short-term liquidity on a dynamic basis over a time horizon spanning from 1-90 days, on a dynamic basis over a time horizon spanning from 1-90 days, banks may estimate their short-term liquidity profiles on the basis banks may estimate their short-term liquidity profiles on the basis of business projections and other commitments. of business projections and other commitments.

An indicative format ( Annexure III for estimating Short-term An indicative format ( Annexure III for estimating Short-term Dynamic Liquidity ) Dynamic Liquidity )

strategies for correcting strategies for correcting mismatchmismatch

Asset driven strategies Asset driven strategies ((securitizatiosecuritization)n)

Liability driven strategies Liability driven strategies hedginghedging

[II] [II] Interest Rate Risk (IRR)Interest Rate Risk (IRR)

““Interest risk is the change in prices of bonds that could occur as a result Interest risk is the change in prices of bonds that could occur as a result of change In interest rates. of change In interest rates.

It also considers change in impact on interest income due to changes in It also considers change in impact on interest income due to changes in the rate of interest “the rate of interest “

Throughout the 1970s and 1980s, the government was borrowing from Throughout the 1970s and 1980s, the government was borrowing from banks using the statutory obligation route at artificially low interest banks using the statutory obligation route at artificially low interest rates ranging fr60 4.5% to 8% (The World Bank, 1995 rates ranging fr60 4.5% to 8% (The World Bank, 1995

Changes in interest rates affect both Changes in interest rates affect both the current earnings (earnings perspective) - changes in NII/NIMthe current earnings (earnings perspective) - changes in NII/NIMthe net worth of the bank (economic value perspective).the net worth of the bank (economic value perspective).

The risk from the earnings' perspective can be measured as The risk from the earnings' perspective can be measured as changes in the Net Interest Income (Nil) or Net Interest changes in the Net Interest Income (Nil) or Net Interest Margin (NIM). Margin (NIM).

The smaller the coupon rate of bonds, larger is the fluctuation associated with The smaller the coupon rate of bonds, larger is the fluctuation associated with

a change in interest rate structure a change in interest rate structure

Because of artificially fixed low coupon rates, commercial banks faced Because of artificially fixed low coupon rates, commercial banks faced

adverse situations when the interest rate structure was liberalized to align adverse situations when the interest rate structure was liberalized to align

with market rates. with market rates.

Therefore, the banking industry in India has substantially more issues Therefore, the banking industry in India has substantially more issues

associated with interest rate risk, which is due to circumstances outside its associated with interest rate risk, which is due to circumstances outside its

control. control.

This poses extra challenges to the banking sector and to that extent; they have This poses extra challenges to the banking sector and to that extent; they have

to adopt innovative and sophisticated techniques to meet some of these to adopt innovative and sophisticated techniques to meet some of these

challenges challenges

Measures available to measure Measures available to measure interest rate risk.interest rate risk.

Maturity: Maturity:

Duration: Duration:

Dollar duration: Dollar duration:

Convexity:Convexity:

Techniques for assessing asset-Techniques for assessing asset-liability risk liability risk

gap analysis gap analysis duration analysis duration analysis scenario analysis scenario analysis Value at RiskValue at Risk SimulationSimulation Model ModelBlack-Scholes model Black-Scholes model Jarrow-Turnbull model Jarrow-Turnbull model

[I]Duration Analysis[I]Duration Analysis

““Duration basically refers to the average life of Duration basically refers to the average life of the asset or the liability”the asset or the liability”

do not address liquidity issues at all do not address liquidity issues at all Measure of the IR sensitivity of assets and Measure of the IR sensitivity of assets and

liabilities liabilities Takes into account the time of arrival of cash Takes into account the time of arrival of cash

flows and the maturity of assets and liabilities flows and the maturity of assets and liabilities The weighted average time to maturity of all The weighted average time to maturity of all

the preset values of cash flows the preset values of cash flows DP p = D ( dR /1+R)DP p = D ( dR /1+R) uses the market value of assets and uses the market value of assets and

liabilities.liabilities.

[II] Gap Analysis Model[II] Gap Analysis Model

““Measures the direction and extent of asset-liability Measures the direction and extent of asset-liability mismatch through either funding or maturity gap. mismatch through either funding or maturity gap.

It is computed for assets and liabilities of differing It is computed for assets and liabilities of differing maturities and is calculated for a set time horizon”maturities and is calculated for a set time horizon”

Looks at the Looks at the re-pricing gap thre-pricing gap that exists between at exists between the interest revenue earned on the bank's assets and the interest revenue earned on the bank's assets and the interest paid on its liabilities the interest paid on its liabilities over a particular period of time over a particular period of time

highlights the NIM exposure of the bank, to changes in highlights the NIM exposure of the bank, to changes in interest rates in different maturity buckets interest rates in different maturity buckets

Repricing gaps are calculated for assets and liabilities of Repricing gaps are calculated for assets and liabilities of differing maturities. differing maturities.

A positive gap indicates that assets get repriced before A positive gap indicates that assets get repriced before liabilities, whereas, a negative gap indicates that liabilities liabilities, whereas, a negative gap indicates that liabilities get repriced before assets get repriced before assets

The general formula that is used is as The general formula that is used is as follows :follows :

NIIiNIIi= = R i (GAPi)R i (GAPi)

NII NII is the net interest income is the net interest income

R R - interest rates impacting assets and - interest rates impacting assets and liabilities in the relevant maturity bucket liabilities in the relevant maturity bucket

GAPGAP – BV(rate sensitive assets)-BV(rate – BV(rate sensitive assets)-BV(rate sensitive liabilities). sensitive liabilities).

[III] [III] SimulationSimulation – (IR) – (IR)““Simulation models help to introduce a dynamic element in Simulation models help to introduce a dynamic element in

the analysis of interest rate risk.the analysis of interest rate risk.

Gap analysis and duration analysis as stand-alone too15 Gap analysis and duration analysis as stand-alone too15 for asset-liability management suffer from their inability for asset-liability management suffer from their inability to move beyond the static analysis of current interest rate to move beyond the static analysis of current interest rate risk exposures “risk exposures “

improves the information available to management in terms of:improves the information available to management in terms of:- Accurate evaluation of current exposures of asset and liability Accurate evaluation of current exposures of asset and liability

portfolios to interest rate risk.portfolios to interest rate risk.- Changes in multiple target variables such as net interest Changes in multiple target variables such as net interest

income, capital adequacy, and liquidity income, capital adequacy, and liquidity - Future gaps.Future gaps.

[IV] [IV] Scenario analysisScenario analysis

Assumptions:Assumptions: several interest rate scenarios would be several interest rate scenarios would be

specified for the next 5 or 10 yearsspecified for the next 5 or 10 years specify declining rates, rising rate's, a gradual specify declining rates, rising rate's, a gradual

decrease in rates followed by a sudden rise, etc decrease in rates followed by a sudden rise, etc specify the behavior of the entire yield curve specify the behavior of the entire yield curve prepayment rates on mortgages or surrender prepayment rates on mortgages or surrender

rates on insurance products rates on insurance products the firm's performance—the rates at which new the firm's performance—the rates at which new

business would be acquired for various product business would be acquired for various product

[V] [V] SecuritizationSecuritization The growth of OTC derivatives markets has The growth of OTC derivatives markets has

facilitated a variety of hedging strategies.facilitated a variety of hedging strategies.

A significant development has been A significant development has been securitization, securitization,

which allows firms to directly address which allows firms to directly address asset-liability risk by removing assets or asset-liability risk by removing assets or liabilities from their balance sheets. liabilities from their balance sheets.

This not only eliminates asset-liability risk; This not only eliminates asset-liability risk; it also frees up the balance sheet for new it also frees up the balance sheet for new

[VI] [VI] Jarrow-Turnbull modelJarrow-Turnbull model Modern risk management now takes place from an integrated Modern risk management now takes place from an integrated

approach to enterprise risk management that reflects the fact approach to enterprise risk management that reflects the fact that interest rate risk, credit risk, market risk, and liquidity risk that interest rate risk, credit risk, market risk, and liquidity risk are all interrelated. are all interrelated.

The Jarrow-Turnbull model is an example of a risk The Jarrow-Turnbull model is an example of a risk management methodology that integrates default and random management methodology that integrates default and random interest rates.interest rates.

Robert C. MertonRobert C. Merton Increasing integrated risk management is done on a Increasing integrated risk management is done on a full mark full mark

to market basis rather than the accounting basis to market basis rather than the accounting basis that was at the that was at the heart of the first interest rate sensivity gap and duration heart of the first interest rate sensivity gap and duration calculations.calculations.

ConclusionConclusion

It is important to note that the It is important to note that the conglomerate conglomerate approach to financial institutions, which is approach to financial institutions, which is increasingly becoming popular in the increasingly becoming popular in the developed markets, could also get replicated in developed markets, could also get replicated in Indian situations. Indian situations.

This implies that the distinction between This implies that the distinction between commercial banks and term lending commercial banks and term lending institutions could become blurred. institutions could become blurred.

It is also possible that the same institution It is also possible that the same institution involves itself in short-term and long-term involves itself in short-term and long-term lending-borrowing activities, as well as other lending-borrowing activities, as well as other activities like mutual funds, insurance and activities like mutual funds, insurance and pension funds. pension funds.

In such a situation, the strategy for asset-In such a situation, the strategy for asset-liability management becomes more liability management becomes more challenging because one has to adopt a challenging because one has to adopt a modular approach modular approach in terms of meeting asset in terms of meeting asset liability management requirements of different liability management requirements of different divisions and product lines. divisions and product lines.

But it also provides opportunities for But it also provides opportunities for diversification across activities that could diversification across activities that could facilitate risk management on an enhanced facilitate risk management on an enhanced footing. footing.

In other words, in the Indian context, the In other words, in the Indian context, the challenge could arise from say the merger challenge could arise from say the merger of SBI, IDBI, and LIC. of SBI, IDBI, and LIC.

Such a scenario need not be considered Such a scenario need not be considered extremely hypothetical because combined extremely hypothetical because combined and stronger balance sheets provide much and stronger balance sheets provide much greater access to global funds.greater access to global funds.

It also enhances the capability of institutions It also enhances the capability of institutions to significantly alter their risk profiles at short to significantly alter their risk profiles at short notice because of the flexibility afforded by notice because of the flexibility afforded by the characteristics of products of different the characteristics of products of different divisions.divisions.

This also requires significant managerial This also requires significant managerial competence in order to have a conglomerate competence in order to have a conglomerate view of such organizations and prepare it for view of such organizations and prepare it for the challenges of the coming decade.the challenges of the coming decade.

As long as the artificial barriers between As long as the artificial barriers between different financial institutions exist, asset different financial institutions exist, asset liability management is narrowly focused liability management is narrowly focused and many a time not in a position to and many a time not in a position to achieve the desired objectives.achieve the desired objectives.

This is because of the fact that the This is because of the fact that the institutional arrangements are mainly due institutional arrangements are mainly due to historical reasons of convenience and a to historical reasons of convenience and a perceived static picture of the operating perceived static picture of the operating world. world.

The integration of different financial markets, The integration of different financial markets, instruments and institutions provide greater instruments and institutions provide greater opportunities opportunities for for emerging markets like India to aim emerging markets like India to aim for higher return in the context of minimizing risk. for higher return in the context of minimizing risk.

Hence, it maybe appropriate to think in terms of Hence, it maybe appropriate to think in terms of reorienting our institutional structures (removing the reorienting our institutional structures (removing the distinctions between commercial banks, non-banking distinctions between commercial banks, non-banking financial companies, and term lending institutions to financial companies, and term lending institutions to start with)start with)

and having a conglomerate regulatory framework for and having a conglomerate regulatory framework for monitoring capital adequacy, liquidity. solvency, monitoring capital adequacy, liquidity. solvency, marketability, etc.marketability, etc.

This will go a long way in ironing out the This will go a long way in ironing out the mismatches between the assets and the mismatches between the assets and the liabilities, rather than narrowly focused asset-liabilities, rather than narrowly focused asset-liability management techniques for individualliability management techniques for individual banks.banks.