Asset Liability Management - Module A

ASSET LIABILITY MANAGEMENTMODULE A

C.S.BALAKRISHNANFACULTY MEMBER,SPBT COLLEGE

COMPONENTS OF ASSETS & LIABILITIES IN BANK’S BALANCE SHEET AND THEIR

MANAGEMENT• Bank’s Liabilities -The sources of funds for the lending and

investment activities constitute liabilities side of balance sheet.

Capital Reserves and Surplus Deposits Borrowings Other Liabilities and Provisions Contingent Liabilities.

Bank’s Assets are the funds mobilised by bank through various sources.

-Cash and Bank balances with Reserve Bank

Of India.

-Balances with banks and money at call and

short notice.

-Investments

-Advances

-Fixed Assets

-Other Assets.

Business of banking involves the identifying,measuring,accepting and managing the risk,the heart of bank financial management is risk management.One of the most important risk-managemnet functions in bank is Asset Liability Management.

Traditionally,administered interest rates were used to price the assets and liabilities of banks.However,in the deregulated environment,competition has narrowed the spreads of banks.

Asset Liability Management is concerned with strategic balance sheet management involving risks caused by changes in interest rates,exchange rate,credit risk and the liquidity position of bank.With profit becoming a key-factor,it has now become imperative for banks to move towards integrated balance sheet management where components of balance sheet and its different maturity mix will be looked at profit angle of the bank.

ALM is about management of Net Interest Margin(NIM) to ensure that its level and riskiness are compatible with risk/return objectives of the bank.It is more than just managing individual assets and liabilities.It is an integrated approach to bank financial management requiring simultaneous decision about types and amount of financial assets and liabilities it holds or its mix and volume.In addition ALM requires an understanding of the market area in which the bank operates.

If 50% of the liabilities are maturing within 1 year but only 10% of the assets are maturing within the same period.Though the financial institution has enough assets,it may become temporarily insolvent due to a severe liquidity crisis.

Thus,ALM is required to match assets & liabilities and minimise liquidity as well as market risk.

Reasons for growing significance of ALM -Volatility -Product Innovation -Regulatory Framework -Management Recognition 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.

Purpose and objectives of asset liability

managementReview the interest rate structure and compare

the same to the interest/product pricing of both assets and liabilities.

Examine the loan and investment portfolios in the light of the foreign exchange risk and liquidity risk that might arise.

Examine the credit risk and contingency risk that may originate either due to rate fluctuations or otherwise and assess the quality of assets.

Review,the actual performance against the projections made and analyse the reasons for any effect on spreads.

Aim is to stabilise the short-term profits,long-term earnings and long-term substance of the bank.The parameters that are selected for the purpose of stabilising asset liability management of banks are:

-Net Interest Income(NII)

-Net Interest Margin(NIM)

-Economic Equity Ratio

Net Interest Income- Interest Income-Interest Expenses.

Net Interest Margin- Net InterestIncome/Average Total Assets

Economic Equity Ratio-The ratio of the shareholders funds to the total assets measures the shifts in the ratio of owned funds to total funds.The fact assesses the sustenance capacity of the bank.

ALM is required to match assets and liabilities

to ---------liquidity risk as well as market risk.The ratio of shareholders funds to the total

assets is called-------.Net Interest Margin is defined as net interest

income divided by ---------.Liquidity is ensured by grouping the

assets/liabilities based on their ------.The institution is in a position to benefit from

rising interest rates when assets are ------ than liabilities

State True or FalseAssets represent source of funds whereas

liabilities denote the use of funds in a balance sheet.

Deregulated environment has narrowed spreads of the banks.

Asset liability management is only management of maturity mismatch and has no bearing on profit augmentation.

Net Interest Margin is known as ‘Spread’

LIQUIDITY MANAGEMENTBanks need liquidity to meet deposit

withdrawal and to fund loan demands.The variability of loan demands and variability

of deposits determine bank’s liquidity needs.It represents the ability to accommodate decreases in liability and to fund increases in assets.

It demonstrates the market place that the bank is safe and therefore capable of repaying its borrowings.

It enables bank to meet its prior loan commitments,whether formal or informal.

It enables bank to avoid the unprofitable sale of assets.

It lowers the size of the default risk premium the bank must pay for funds.

Types of liquidity risk:

-Funding Risk

-Time Risk

-Call Risk.

Funding Risk:

Need to replace net outflows due to unanticipated withdrawal/non-renewal of deposits arises due to :-Fraud causing substantial loss

-Systemic Risk

-Loss of confidence

-Liabilities in foreign currencies

Time Risk:

Need to compensate for non-receipt of expected inflow of funds,arises due to,

-Severe deterioration in the asset quality

-Standard assets turning into non-performing

assets

-Temporary problems in recovery

-Time involved in managing liquidity.

Call Risk:Crystallisation of contingent liabilities and inability to undertake profitable business oppurtunities when desirable,arises due to,

-Conversion of non-fund based limit into fund

based.

-Swaps and options.

Measuring and Managing Liquidity RiskDeveloping a structure for managing liquidity

risk.Setting tolerance level and limit for liquidity

risk.Measuring and managing liquidity risk.

Setting tolerance level for a bank:

To manage the mismatch levels so as to avert wide liquidity gaps-The residual maturity profile of assets and liabilities will be such that mismatch level for time bucket of 1-14 days and 15-28 days remain around 20% of cash outflows in each time bucket.

To manage liquidity and remain solvent by maintaining short-term cumulative gap up to one year(short term liabilities-short term assets at 15% of total outflow of funds.

Measuring and Managing Liquidity Risk

Stock Approach

Flow Approach

Stock Approach is based on the level of assets and liabilities as well as off balance sheet exposures on a particular date.The following ratios are calculated to assess the liquidity position of the bank:

Ratio of core deposits to total assets

Net loans to total deposits ratio

Ratio of time deposits to total deposits

Ratio of volatile liabilities to total assets

Ratio of short term liabilities to liquid assetsRatio of liquid assets to total assetsRatio of short term liabilities to total assetsRatio of prime assets to total assetsRatio of market liabilities to total assets.

Flow Approach

-Measuring and managing net funding

requirements.

-Managing Market Access

-Contingency Planning

Measuring and Managing net funding Requirements:Flow method is the basic approach followed by Indian Banks.It is called as gap method of measuring and managing liquidity.It requires the preparation of structural liquidity gap report.In this method net funding requirement is calculated on the basis of residual maturiries of assets & liabilities.These residual maturities represent net cash flows ie.difference between

cash outflow & cash inflow in future time buckets

These calculations are based on the past behaviour pattern of assets and liabilities as well as off balance sheetexposures.Cumulative gap is calculated at various time buckets.In case gap is negative bank has to manage the shortfall.

The analysis of net funding requirements involves the construction of a maturity ladder and the calculation of a cumulative net excess or deficit of funds at selected maturity dates.

Objective of liquidity management is to

a)Ensure profitability

b)Ensure liquidity

c)Either of two

d)Both Banks need liquidity to

a) Meet deposit withdrawal

b) Fund loan demands

c) Both of them

d) None of them.

Adequacy of a bank’s liquidity position depends upon:

a)Sources of funds

b)Anticipated future funding needs

c)Present and Future earnings capacity

d)All the above

The need to replace net outflows due to unanticipated withdrawal of deposits is known as ---------risk.

The need to compensate for non-receipt of expected inflows of funds is classified as -----risk.

Call risk arises due to crystallisation of ------.Maturity ladders enables the bank to estimate

the difference between-----and------in predetermined periods.

Liquidity management methodology of evaluating whether a bank has sufficient liquid funds based on the behaviour of cash flows under different what if scenarios is known as -------.

The capability of bank to withstand a net funding requirement in a bank specific or general market liquidity crisis is denoted as----

INTEREST RATE RISK MANAGEMENT

Interest rate risk is the volatility in net interest income(NII) or in variations in net interest margin(NIM).

Gap:The gap is the difference between the amount of assets and liabilities on which the interest rates are reset during a given period.

Basis risk:The risk that the interest rate of different assets and liabilities may change in different magnitudes is called basis risk.

Embedded option:Prepayment of loans and bonds and/or premature withdrawal of deposits before their stated maturity dates.

Yield curve:It is a line on a graph plotting the yield of all maturities of a particular instrument.

Changes in interest rates also affect the

underlying value of the bank’s--------

Rise in interest rates-----the market value of that

asset and fall in interest rate ----the market value

of assets or liabilities.

The gap is the difference between the amount

of assets and liabilities on which interest rates

are------during a given period

• Mismatch occurs when assets and liabilities fall due for -----in different periods

• The economic value of a bank can be viewed

as the present value of the bank’s expected

-------.

Estimates derived from a standard duration generally focus on just one form of interest rate risk exposure ie.-----

The adverse impact on NII due to mismatches can be minimised by fixing appropriate ----on interest rate sensitivity gaps.

Management of Exchange Rate Risk

• Foreign exchange risk-Risk arising out of adverse exchange rate movementsduring a period in which it has open position in an individual foreign currency.

• Transaction exposure:Change in the foreign exchange rate between the time the transaction is executed and the time it is settled.

• Forwards-Agreement to buy or sell forex for a predetermined amount,at a predetermined rate on a predetermined date.

Open position:The extent to which outstanding contracts to purchase a currency exceed liabilities plus outstanding contractsto sell the currency & vice versa.

Overnight position-A limit on the maximum open position left overnight,in all major currencies.

Day-light position-A limit on maximum open position in all major currencies at any point of time during day.Such limits are generally larger than overnight positions.

• Options:It is a contract for future delivery of a currency in exchange for another,where the holder of the option has the right,without obligation to buy or sell the currency at an agreed price,the strike price or exercise price,on a specified future date.

• Call option;The right to buy under an option• Put option:The right to sell under an option.• Futures are forward contracts with standardized

size,standardised maturity date governed by a set of guidelines stipulated by exchange concerned for settlements and payments.

An appreciation in domestic currency will----

value of assets and liabilities.

In a forward contract actual cash flow occurs on

the date of-----

Swaps can be of two types----and------

RBI GUIDELINES

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