Asset Liability Management Asset-Liability Management Policy Asset and Liability Management (ALM) is the process of managing the structure of a bank’s.

Asset Liability Management

Asset-Liability Management Policy• Asset and Liability Management (ALM) is

the process of managing the structure of a bank’s balance sheet by which interest earnings are maximized within expected risk level undertaken during the course of business.

• It manages various types of risks associated with assets and liabilities of a bank.


• Business enterprises have always managed assets and liabilities.

• Any nonfinancial corporation must decide:– which assets to acquire (asset management), – how much to maintain as equity capital (capital

management), – how much to hold as inventories and other working

capital (liquidity and cash management), and – must ascertain and deal with :

• exchange rate variations, • interest rate changes and • the other business risks to which it is exposed (risk

management).


• Similarly, banks and other financial institutions, have to determine: – what loans and investments to make, – how to finance them by taking deposits and

issuing equity, – how much to hold as cash reserves and other

liquid assets, and – they have to take account of

• how interest rate margins and fees respond to financial conditions.


• Thus Asset and liability management can be defined as a planning procedure which manages assets and liabilities by:– Amount– Maturity– Sensitivity to rates (interest and exchange rates),

and – Other characteristics.


• The aim is to:– Identify– Measure and– Control

• those factors which influence and thus have the potential to affect adversely the net worth of the enterprise.


Aspects Of Asset Liability Management.– Cash Management– Funds Management– Risk Management

• Credit Risk

• Market Risk

• Interest Rate Risk

• Operational Risk


Cash Management• Both financial and non financial enterprises extend

and receive credit as part of continuing business operations and hold an inventory of liquid resources to shield illiquid earning assets from unexpected cash outflows.

• Corporate treasurers are responsible for the management of working capital, which includes cash.


• Current assets consist of cash, bank deposits, short-term notes, accounts receivable, inventories and the difference between these items and current liabilities is working capital.

• Bank treasuries oversee holdings of currency, reserve balance at the central bank and other liquid assets.


• High nominal interest rates have provided business firms with an incentive to reduce idle bank balances; at the same time bankers want to keep their cash and operational accounts at the central bank to a minimum


FUNDS MANAGEMENT.• Large scale demand for financing have spurred the

development of new modes of financing (syndicated loans, term loans, project finance, leasing) in a variety of currencies.

• In turn, interbank and wholesale fund markets have evolved to channel savings to the banks and specialized lending institutions providing this finance.


• These new markets have widened the funding opportunities open to both corporate and bank treasuries.

• These are the the possibilities: – the mix of fixed rate and floating rate borrowings needs

to be juxtaposed with the choice of short-term and long-term funding and also that of the currency of denomination.

• A wide variety of instruments provide for these choices


• Traditionally banks have looked to the assets side for liquidity; in particular, the idea that banks should confine themselves to self-liquidating loans (e.g. trade bills), and repay deposits from the receipts of maturing assets,

• In more recent times the emphasis is upon shiftable assets, that is assets which can be sold on strong and active organized markets (e.g. Government Bonds).


• Later on, there took place a switch to liability management, that is buying in liquidity as needed from wholesale funding markets, for instance by issuing certificates of deposit or by borrowing interbank.

• Many large banks began to use these markets as a more or less permanent source of funds for lending.


• The current vogue for asset and liability management implies an integrated approach to funds management in which asset management and liability management emerge as special cases.

• At one extreme, a bank could fix deposit interest rates and allow the scale of the asset portfolio to vary in line with the quantity of deposits forthcoming at the posted rates (pure asset management).


• Alternatively, by adjusting interest rates paid on liabilities so as to induce a quantity of deposits equal to the pre-existing stock of assets, all of the liquidity disturbances could fall upon prices (pure liability management).

• But mixed strategies are the norm.


Some Relevant Issues on Funds Management:

• The run on Continental Illinois Bank in 1984.

• The case of Northern Rock Bank in UK

• The concentration over Savings Deposit

• The cases of Lottery in Bank Deposits

• The Reduction by some Banks in Saving Deposits.


U.S. Treasurys Close 11/20/2007

• Time Yield Change• 1 Month 3.54 -0.21• 3 Month 3.27 -0.13• 6 Month 3.43 -0.09• 2 Year 3.20 -0.03• 5 Year 3.55 -0.05• 10 Year 4.10 -0.02• 30 Year 4.50 -0.01

RISK MANAGEMENT.

• Every business is faced with a number of risks

• These risks also confront banks and other financial institutions. • On the balance sheet, banks accommodate to customers'

demands for assets and liabilities which have different maturities (e.g. short-term deposits and long-term loans), different currency denominations, and different degrees of interest rate flexibility, thereby taking on exchange rate and interest rate risks.

•

• In addition, both on and off balance sheet, banks may deliberately open up exposures based on their expectations about market trends.

• Asset and liability management by banks involved managing these risks.

Credit Risk • Credit Risk is the risk that a borrower is unable to meet its

financial obligations to the lender.• For this purpose Banks generally measure, monitor and

manage credit risk for each borrower • Standardized credit approval processes, which include a

well-established procedure of comprehensive credit appraisal and rating are followed

• Banks develop internal credit rating methodologies for rating obligors as well as for products/facilities.

• The rating takes into consideration the quantitative and qualitative issues and credit enhancement features specific to the transaction.

• The rating serves as a key input in the approval as well as post-approval credit processes.

• The rating for every borrower is reviewed at least annually and for higher risk credits and large exposures on a more regular basis.

• Industry knowledge is constantly updated through field visits, interactions with clients, regulatory bodies and industry experts.

• In respect of retail credit products, a system of centralised approval of all products and policies and monitoring of the retail portfolio are followed.

• Banks continuously refine their retail credit parameters based on portfolio analysis.

Market Risk• Market Risk is the risk of loss resulting from

changes in interest rates, foreign currency exchange rates, equity prices and commodity prices.

• Bank’s exposure to market risk is a function of their trading and asset liability management activities and their role as a financial intermediary in customer-related transactions.

• The objective of market risk management is to minimize the impact of losses due to market risk, on earning and equity capital.

• Market risk policies include asset-liability management (ALM) policies and policies for the investment portfolio.

• ALM policies are approved by the Asset-Liability Management Committee (ALCO) of the Board of directors.

• ALCO's role encompasses stipulating liquidity and interest-rate risk limits, monitoring risk levels by adherence to set limits, articulating the organizations' interest rate view and determining business strategy in the light of the current and expected business environment.

• These sets of policies and processes are articulated in the ALM policy.

• A separate set of policies for the investment portfolio address issues related to investments in various investment products and are approved by the appropriate authority.

• Interest rate risk is measured through the use of re-pricing gap analysis and duration analysis.

• Liquidity risk is measured through gap analysis.

• Banks ensure adequate liquidity at all times through systematic funds planning and maintenance of liquid investments as well as by focusing on more stable funding sources such as retail deposits.

• Banks mitigate their exposure to exchange rate risk by stipulating daily stop-loss limits and position limits.

• The Treasury Middle Office Group monitors the asset-liability position under the supervision of the ALCO.

• It also monitors treasury activities, including determining compliance with various exposure and dealing limits, verifying the appropriateness and accuracy of various transactions, confirming these transactions, tracking the daily funds position and all treasury-related management and regulatory reporting.

Operational Risk• Operational Risk can result from a variety of factors,

including failure to obtain proper internal authorizations, improperly documented transactions, failure of operational and information security procedures, computer systems, software or equipment, fraud, inadequate training and employee errors.

• Banks attempt to mitigate operational risk by maintaining a comprehensive system of internal controls, establishing systems and procedures to monitor transactions, maintaining key back-up procedures and undertaking regular contingency planning.

• Processes are generally categorized based on the frequency and impact of the operational risk that they carry.

• Based on this classification, mitigants are outlined to reduce the risk,

• Initiation of work on modeling the impact of losses arising out of operational risk inherent in different processes as part of the new Basel Capital Accord are undertaken.

• The Middle Office Group monitors adherence to credit and investment procedures.

• The Internal Audit Group undertakes a comprehensive audit of business groups and other functions, in accordance with a risk-based audit plan.

• This audit plan allocates audit resources based on an assessment of the operational risks in the various business.

• Banks have been a pioneer in the implementation of a risk-based audit methodology in the banking sector.

• The Internal Audit Groups conceptualizes and implements improved systems of internal controls to minimize operational risk.

Interest Rate Risk Management Tools• Bankers have developed a number of

analytical tools to quantify and manage these risks.

• These are– Basic gap analysis – Maturity buckets – Duration– Simulation

Basic gap analysis. • This focuses on the gap between rate sensitive assets (RSA)

and rate sensitive liabilities (RSL), or its mirror image in terms of the difference between fixed rate liabilities (FRL) and fixed rate assets (FRA)

• As all interest rates respond to market conditions given a long enough time horizon, some time period (e.g.twelve months) must be chosen.

• Thus rate sensitive means assets and liabilities that are repriced within the chosen period.

• RSA would include floating rate loans and maturing investments, while RSL would include floating rate liabilities, short-term deposits and maturing CDs.

• When RSA is greater than RSL (or FRL is greater than FRA), the institution's net interest income is exposed to losses should interest rates fall.

• Conversely, when RSA is less than RSL FRL is less than FRA, losses can occur should rates rise.

Maturity buckets. • Since assets and liabilities may be repriced at different time

within the gapping period of, say, twelve months, balance sheet items can be grouped into a number of time intervals ('buckets') according to maturity/ repricing periods.

• Typically the buckets will have intervals of 0-30 days, 30-60 days, 60-90 days and so on.

• The gap for each bucket is calculated, conventionally, as the amount of rate sensitive assets less rate sensitive liabilities.

• However, early repayment of loans can create a gap which is difficult to quantify, and the same is true of the uncertain drawdown of loans

• Also, even if RSA and RSL are equal, the interest rate changes for assets and liabilities may not be of the same magnitude.

• Such different repricing behavior is the basis of the standardized gap which adjusts gap measures for the relative measures for the relative volatilities of various financial instruments.

Duration. • In contrast with Basic gap analysis and Maturity

bucket perspectives, duration provides a concise economic measure of the sensitivity of market values to changing interest rates

• Duration being the elasticity of security prices with respect to interest rates.

• It aims to capture in a single number an institution's interest rate exposure.

• For example, if the average duration of a bank's assets is six months and that of its liabilities is three months, then any increase in interest rates will lead to a drop in the value of assets twice the magnitude of the decline in the worth of liabilities.

• This simplicity is the measure's great advantage

• The disadvantage is its implicit assumption that the yield curve (term structure of interest rates) shifts in a parallel fashion which patently is not the case.

• In finance, duration is the weighted average maturity of a bond's cash flows or of any series of linked cash flows.

• Thus the duration of a zero coupon bond with a maturity period of n years is n years.

• If there are coupon payments, the duration will be less than n years.

• This measure is closely related to the derivative of the bond's price function with respect to the interest rate, and some authors consider the duration to be this derivative divided by the price, with the weighted average maturity simply being an easy method of calculating the duration for a non-callable bond.

• It is sometimes explained in inaccurate terms as being a measurement of how long, in years, it takes for the price of a bond to be repaid by its internal cash flows.

• Duration is useful as a measure of the sensitivity of a bond's price to interest rate movements.

• It is approximately proportional to the percentage change in price for a given change in yield.

• For example, for small interest-rate changes, the duration is the approximate percentage that the value of the bond will lose for a 1% increase in interest rates.

• So a 15-year bond with a duration of 7 would fall approximately 7% in value if the interest rate increased by 1%.

Simulation• In this method, computer models are used to

simulate the effects of a wide number of interest rate scenarios upon a bank's balance sheet and profit and loss account.

• While useful for examining various forecasts and projections, such techniques require considerable data collection and rest heavily on the 'what if' assumptions employed.

Value At Risk (VAR )• A number of risk measurement techniques was developed during the last

two decades. • However, in 1993 Group of Thirty, a consultative group of top bankers,

financiers and academics from leading industrial nations made recommendations to value positions at market rates and assess financial risks using Value-At-Risk system.

• Rating Agencies like Moody's and S&P and ISDA also put forth similar recommendations.

• The most notable initiative is that of J.P.Morgan's system of measuring VAR Called "Risk Metrics".

• Compared to this system which is basically data-fed, Bankers Trust came out with a system known as RAROC 2020, which is based on internal risk management experience

• But what is VAR? – VAR is a method of assessing risk that uses standard statistical

techniques routinely used in other technical fields.

• Formally, VAR measures – the worst expected loss, over a given time interval, under normal

market conditions, at a given confidence level

• VAR thus provides with a summary measure of market risk. • For example:

– considering a holding period of 10 days, and – a 95% confidence interval,

• a Rs100 VAR signifies that: – there is 95% chance that the loss in the value of portfolio on a 10-

day period will be less than Rs. 100.

• This single number represents the bank's total exposures to market risk as well as the possibility of an adverse move.

• In its most general form VAR can be derived from the probability distribution of future portfolio value taking the cue from the assumed fact that history in all probability repeats itself.

• Individually VAR of assets can be worked out for foreign currency spot/forward positions or options, call option on common shares, fixed income securities etc.

• While apparently the computation would look formidable, the availability of standard software has made the task easier to derive the "single number".

• The application of VAR concept could be done in a number of areas of the banks' operations. – Firstly, it can be useful for fine tuning Asset/Liability management by

estimating the volatility of Net Interest Income using the required confidence interval and the corresponding interest rate scenario.

– Secondly, the most important area where the application of the concept has the greatest potentiality is in the area of trading risk management. In fact limits can be set for the entire trading operation and for each type of risk etc.

– Thirdly, VAR can be an essential tool to communicate to shareholders the financial or market risks through its disclosure in annual reports. Reporting of actual change in portfolio value corresponding to the reported VAR also enables users to asses the effectiveness of internal risk-management system.

– Fourthly, VAR model helps to decide how to allocate limited resources and it creates a common denominator with which to compare various risky activities.

– Fifthly, a major use of VAR can be for performance evaluation i.e. linking trader's profitability to the amount of risk taken by him.

• In the area of regulatory applications VAR helps assessment of potential capital adequacy.

• To obtain total capital adequacy requirements banks can add their credit-risk charge to their market risk charge applied to trading operation.

• Also this may assist bank auditors monitor performance verification and judge the safety and soundness of the institution.

• However it needs to noted that the VAR System is not perfect: – as prices may respond in a non-linear fashion, – as correlations are also subject to changes and – as the past is not always a good approximation of the future.

• Yet, there is no gain saying that VAR makes a beginning to delve into the realm of uncertainty associated with risk.

• Financial system should, therefore, attach sufficient priority to the introduction of the concept.

• The sooner they do it the better instead of simply ignoring it on the plea that proper appreciation and understanding of subject is yet to sink in.

• It is to be remembered that global integration is taking place too fast.