Mba Project

An Insight into the Asset Liability Management of Mutual Trust Bank Limited

C HAPTER-1

INTRODUCTION

1.1 INTRODUCTION:

Asset Liability management is very much importance for a bank. Banks are making profit

from various services provided to their customers. Banks profit is functions of revenue

earned form the assets and the cost incurred for the liability that has occurred for

acquiring funds for financing the assets. Proper management of bank assets and liabilities

can increase the profitability of the bank. The fuming of these loans and advances and

investments comes from liability. So the earnings of a bank ultimately depend on

liabilities. Banks have to incur costs for its liability. For example, they have to give

interest to the public and also to the lending institutions. So banks liability is not cost

free. Efficient use of liabilities depends on effective liability management. Effective

liability management indicates that the cost of the liability will be less and also it will less

volatile. But less cost and less volatility is inversely related. If we give our concentration

only to less cost fund, then the funds will be volatile. Again if we give our attention to

only to less volatility, then the cost of fund will be high because only the fixed deposit

has the characteristics of less volatility. So we have to make coordination between least

costs fund and least volatile fund.

ALM has mainly two components. One is asset management and the other is liability

management. Asset management deals with how a manager can appropriately handle the

assets of the bank and efficiently use the profitable opportunities. On the other hand,

liability management deals with the liability side of the balance sheet. A bank’s earning

or spread is the difference between the revenue generated mainly from the asset side of

the business and expense generated mainly from the liability side of the business. The

foal of liability management is to gain control over the bank’s funds sources.

Almost in every moment in our life we are confronted with different types of risk. Human

mind is programmed to learn to manage risk. Managing risk is unique and fundamental in

banking industry, because unlike other industry it is exposed to multi-dimensional risks

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that has aggravated with the advent of deregulation and globalization. No banking

industry in the world is isolated from the risks, and in this project paper my efforts should

concentrate on understanding and appreciating these risks specially managing asset and

liability so that I can learn more how can manage them efficiently, appropriately and in a

timely manner. The major risks that a bank encounters in its business are as follows:

1) Asset Liability Management Risk

2) Credit/ Lending Risk

3) Foreign Exchange Risk

4) Internal Control and Compliance Risk

5) Money Laundering Risk

This Project paper is based on “An Insight into the Asset Liability management of Mutual

Trust Bank Limited”. To manage the above risk effectively and to ensure sustainable

performance and good governance of the banking company, the following requirements

must be fulfilled:

1) An effective regulatory frame work

2) A sound operations system to support the regulatory framework.

3) A Socio ethical standard to ensure that the people engaged in the organization is

committed towards their stakeholders in a meaningful way.

Given the fact that an appropriate asset liability management system was required to

manage risk better.

1.2 RATIONALE OF THE STUDY:

I am preparing this report to know the insight of the asset liability Management of a bank.

Sample Bank:

Mutual Trust Bank Limited

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1.3 SCOPE OF THE STUDY:

As my supervisor is very helpful and cooperative, I got some privilege to prepare this report. As

one of my friends is an employee of Mutual trust Bank, I have special opportunity to collect

important and sensitive data, which make this report different from others.

1.4 OBJECTIVE OF THE STUDY:

The main objectives of preparing this Report

To identify the management of asset and liability of Mutual Trust Bank Ltd.

To analyze and find out degree of risks involved in each area.

To suggest how to manage this area’s risks for minimizing the risk.

1.5 METHODOLOGY:

1.5.1 Sources of Data Collection:

To undertake the study in the light of research objectives, information both from the

primary and secondary sources are necessary. However, first, in order to build up

theoretical premise, standard textbooks, reference books, domestic and foreign journals

and other related literature have been collected from annual reports and other official

records of the banks.

1.5.2 Data Analysis:

The collected information has then been tabulated, analyzed and the findings thereof have

laid the basis of research report. Data processing and analysis has been done both

manually and by using computer. Tabular method, ratio analysis, and suitable statistical

tools and techniques have been used to operationally the research where required.

1.6 LIMITATIONS OF THE STUDY:

There were some problems while this research is conducted. A wholehearted effort was

applied to overcome the limitations and to bring a reliable and fruitful result. In spite of

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having the wholehearted effort, there exist some limitations, which acted as a barrier to

conduct the research. The limitations were—

1. The major problem faced while conducting the research was unavailability of

relevant data. No banks provided the costs of their particular liability. Even

some banks did not agree to give their annual reports.

2. No banks provided the cost components of their liabilities. That’s why the cost

of various liabilities is assumed on the basis of historical trend.

3. While utmost care has been given to cover every part of Asset Liability

Management, a few complex issues related to Market Risk have not been

covered in details.

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End of Chapter 1CHAPTER 2

THEORETICAL DEVELOPMENT

2.1 ASSET-LIABILITY MANAGEMENT (ALM):

Asset-liability management (ALM) is a term whose meaning has evolved. It is used in

slightly different ways in different contexts. ALM was pioneered by financial institutions,

but corporations now also apply ALM techniques.

Traditionally, banks and insurance companies used accrual accounting for essentially all

their assets and liabilities. They would take on liabilities, such as deposits, life insurance

policies or annuities. They would invest the proceeds from these liabilities in assets such

as loans, bonds or real estate. All assets and liabilities were held at book value. Doing so

disguised possible risks arising from how the assets and liabilities were structured.

2.2 ASSET LIABILITY MANAGEMENT POLICY:

Asset Liability Management (ALM) is an integral part of Bank Management; and so, it is

essential to have a structured and systematic process for manage the Balance Sheet.

Banks must have a committee comprising of the senior management of the bank to make

important decisions related to the Balance Sheet of the Bank. The committee, typically

called the Asset Liability Committee (ALCO), should meet at least once every month to

analysis, review and formulate strategy to manage the balance sheet. In every ALCO

meeting, the key points of the discussion should be minted and the action points should

be highlighted to better position the bank’s balance sheet.

Asset Liability management is one of the pillars of banking- in fact the concept of Asset Liability

management is at the core of financial business. The importance of appropriate and effective

Asset Liability management has always been outlined by regulators, market operatives and

individuals and yet we hear of instances of failures in Asset Liability management mechanism-

the most notable amongst them the Barings Bank and Long Term Capital Management.

The Asset Liability Risk Management system essentially focuses on risks that arise out of

liquidity and interest rate mismatches and management of Capital Adequacy. This aspect of risk

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management has become increasingly important due to volatility that arises from a deregulated

market- driven environment. Here to the policy guideline, outlines all the areas that are required

to be covered through preciously laid down statement on Capital Adequacy, borrowing limits

commitment limits, loan deposit ratios and medium term funding ratio. The organization structure

and job responsibilities are also outlined and the globally accepted ALCO or The Asset Liability

Committee process is detailed. The ALCO process ensures that the management is constantly

apprised of the risks arising out of liquidity and interest rate mismatch and step can be taken

through this continuous monitoring of risk to manage it effectively.

2.3 ASSET LIABILITY MANAGEMENT POLICY EFFICIENT FRONTIER:

The five step ALMEF process:

1. Economic evaluation of the balance sheet which considers the ongoing nature of the

business.

2. Evaluation of capital markets employing a stochastic economic simulation model,

3. Surplus optimization utilizing a multi-time period non-linear optimization model

which develops efficient frontier portfolios that explicitly consider the liability cash flows

and characteristics, as well as being dynamically linked to changing capital market

scenarios.

4. Sensitivity testing of key asset, liability and capital market factors. And

5. A performance measurement system that culminates in a liability benchmark index.

The process loops back to step one at various stages and is reevaluated on an ongoing

basis. A diagram of the process is provided below. The result is a prospective investment

policy and strategy that considers not only the liability profile for the existing balance,

but also how the balance sheet will look going forward.

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Over the last few years the Bangladesh’s financial markets have witnessed wide ranging

changes at fast pace. Intense competition for business involving both the assets and

liabilities, together with increasing volatility in the domestic interest rates as well as

foreign exchange rates, has brought pressure on the management of banks to maintain a

good balance among spreads, profitability and long-term viability. These pressures call

for structured and comprehensive measures and not just ad hoc action. The Management

of banks has to base their business decisions on a dynamic and integrated risk

management system and process, driven by corporate strategy. Banks are exposed to

several major risks in the course of their business - credit risk, interest rate risk, foreign

exchange risk, equity / commodity price risk, liquidity risk and operational risks.

2.4 ALM INFORMATION SYSTEMS:

Information is the key to the ALM process. Considering the large network of branches

and the lack of an adequate system to collect information required for ALM which

analyses information on the basis of residual maturity and behavioral pattern it will take

time for banks in the present state to get the requisite information. The problem of ALM

needs to be addressed by following an ABC approach i.e. analyzing the behavior of asset

and liability products in the top branches accounting for significant business and then

making rational assumptions about the way in which assets and liabilities would behave

in other branches. In respect of foreign exchange, investment portfolio and money market

operations, in view of the centralized nature of the functions, it would be much easier to

collect reliable information. The data and assumptions can then be refined over time as

the bank management gain experience of conducting business within an ALM

framework. The spread of computerization will also help banks in accessing data.

2.5 ALM PROCESS:

The scope of ALM function can be described as follows:

Liquidity risk management

Management of market risks (Including Interest Rate Risk)

Funding and capital planning

Profit planning and growth projection

Trading risk management

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The guidelines given in this note mainly address Liquidity and Interest Rate risks. The

Asset Liability Committee (ALCO) is responsible for balance sheet (asset liability) risk

management. Managing the asset liability is the most important responsibility of a bank

as it runs the risks for not only the bank, but also the thousands of depositors who put

money into it.

The responsibility of Asset liability Management is on the Treasury Department of the

bank. Specifically, the Asset liability Management (ALM) desk of the Treasury

Department manages the balance sheet. The results of balance sheet analysis along with

recommendation is placed in the ALCO meeting by the Treasurer where important

decisions are made to minimize risk and maximize returns. Typically, the organizational

structure looks like the following:

2.6 ASSET LIABILITY STRUCTURE OF A BANK:

To understand how a bank operates, first we examine the bank balance sheet, which lists

its assets and liabilities. As the name implies, this list balance, that is, it has the

characteristics that—

Total Assets = Total Liabilities + Capital

Furthermore, a bank’s balance sheet lists sources of bank’s funds (liabilities) and uses to

which they are pit (assets). Banks obtain funds by borrowing and by issuing other

liabilities such as deposits. They then use these funds to acquire assets such as securities

and loans. The revenue that banks receive from their holdings of securities and loans

covers the expenses of issuing liabilities and ideally yields a profit.

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2.6.1 Asset Securitization:

Against the backing of the secured assets banks issue security paper to raise funds.

Securitizing assets requires a bank to set aside a group of income earning assets – such as

mortgages or consumer loans – and to sell securities against those assets in the open

market. For example, a bank disbursed loan for two years, so for two years these loans

are illiquid. Bank can issue stock for that amount and for two years. The result is that

they raise funds. The important issues are that—

Loans have to be good loans.

Not deposit collection is necessary for that purpose.

Bank’s loan and revenues can be increased.

So, we can say, securitization is the transformation of illiquid assets into security that is

tradable and further liquid. The important aspects are—

Here the institution has to be rated by the credit rating company.

Securitization has to be done from similar loans.

When banks are offering security, they offer return to investor less than their loan interest

but higher than the deposit return.

2.6.2 Benefits of Securitization:

Additional sources of fund: Bank raises funds other than deposit and non-

deposit items.

Positive effect on balance sheet: Due to of security backed by good loans bank

raises funds, part of which is kept as cash balance and most of which is disbursed

further as loan for good loan request and for further transformation. So banks risk

weighted assets as well as capital adequacy requirements decrease. The result is

that bank’s earning increases.

No opportunity cost of fund: Bank does not need to incur anything such as

borrowing or deposit collection for raising the funds. So there does not involve

any cost.

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Multiple effects for the development of the economy: By securitization, a bank

can raise funds without gong to deposit and non deposit sources. This increases

the bank’s liquidity and profitability. By this process, bank can fund various

prospective investment opportunities. It increases more opportunity for the

community and helps in increasing the per capita income. Security will not only

increase liquidity and reduce pressure on the balance sheet of the bank, but also

help to increase the supply of good scripts in the security market. Thus, it ensures

the financial development of the country.

2.6.3 Risk Involved:

If backed assets become bad loans then banks will loss those loans as well as has to pay

principal and interest tot the investors who bought the “security”. Any loans pledged

behind these securities must be held on the banks balance sheet until the security papers

reach maturity, which decreases the overall liquidity of the bank’s loan portfolio.

Moreover, with these loans remaining on its balance sheet the bank must meet the

regulatory imposed capital requirements to back the loans.

2.6.4 Loan Selling:

It is the selling of some loan to some other intuitions or individuals. It generates cash but

it does not require issuing new security paper.

Loan selling is both with recourse i.e. if the buyer of the loan become unable to get the

money back from the borrower then the seller of the loan will be liable. It may be without

recourse i.e. the buyer of the loan will not get protection in case of being unable to collect

the loan. The advantages of loan selling are it reduces risk and reduces the pressure on

loan. The disadvantage of the loan selling is that due to market pressure; if one sells the

good loans, then it will create adverse impact on the financial position of the bank. Loan

selling is of following types—

2.6.4.1 Loan participation:

First the bank is giving loan and then asks some other parties to participate in the process.

The participator must the outsider. The participator does not involve in the disbursement

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of the loan. The buyer of participation will face a substantial loss if the selling institution

or the borrower fails.

2.4.4.2 Loan striping:

A loan strip is short dated pieces of a longer-term loan and often matures quickly—a few

days or weeks. It is striping some parentage of the loan and sells it to some other

institutions. The purchasing institution will be liable for the collection of that portion of

the loan. The difference between participation and striping is that in striping a

relationship between the buyer of the loan and the borrower creates.

2.6.4.3 Standby Letter of Credit:

It is a financial guarantee in the form of letter of credit. It is mainly practiced in the North

American countries. It is made of r two purposes. Performance bond guarantee: in the

developed market, nobody will purchase the security paper of any institution without

guarantee given by bank.

2.6.4.4 Default Guarantee:

Through it, banks are giving guarantee that if its customer defaults, then the bank will

repay the money.

This note lays down broad guidelines in respect of interest rate and liquidity risks

management systems in banks which form part of the Asset-Liability Management

(ALM) function. The initial focus of the ALM function would be to enforce the risk

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

objective of good risk management programmes should be that these programmes will

evolve into a strategic tool for bank management

End of Chapter 2

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CHAPTER 3

ADMINISTRATION OF ALM

There is a separate department to manage asset and liability. The treasury department

maintains asset and liability of a bank.

3.1 ORGANIZATIONAL STRUCTURE:

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CEO / MANAGING

DIRECTOR

Head of

Consumer

Banking

Head of Consumer BankingHead of

Treasury

Head of

Corporate

Banking

Head of

Finance

Head of

Credit

Head of

Operations

Head of Asset

Liability Mgt

(ALM)

Money Market

Dealers

Treasury: Responsible for ALM


3.2 To maintain asset and liability treasury department has a policy to follow. This

policy guideline is given below:

POLICY GUIDELINES:

3.2.1 Responsibility of the Board of Directors:

The overall responsibility of establishing broad business strategy, significant

policies and understanding significant risks of the bank rests with the Board of

Directors.

Through the establishment of ‘Audit Committee’ the Board of Directors can

monitor the effectiveness of internal control system. Bangladesh Bank has already

instructed the banks to establish Audit Committee.

The internal as well as external audit reports will be sent to the board without any

intervention of the bank management and ensure that the management takes

timely and necessary actions as per the recommendations

Have periodic review meetings with the senior management to discuss the

effectiveness of the internal control system of the bank and ensure that the

management has taken appropriate actions as per the recommendations of the

auditors and internal control.

3.2.2 Responsibility of the Senior Management:

In setting out a strong internal control framework within the organization the role

of Managing Director is very important. He/she will establish a Management

Committee’ (MANCOM), which will be responsible for the overall management

of the Bank

With governance & guidance from the Board of Directors the MANCOM will put

in place policies and procedures to identify, measure, monitor and control these

risks.

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The MANCOM will put in place an internal control structure in the banking

organization, which will assign clear responsibility, authority and reporting

relationship.

The MANCOM will monitor the adequacy and effectiveness of the internal

control system based on the bank’s established policy & procedure.

The MANCOM will review on a yearly basis the overall effectiveness of the

control system of the organization and provide a certification on a yearly basis to

the Board of Directors on the effectiveness of Internal Control policy, practice

and procedure

3.2.3 ALCO & Asset Liability Management (ALM):

The bank’s asset liability management is monitored through ALCO. The information

flow in the ALCO can be diagramed as below:

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The Committee:

As the Treasury Department is primarily responsible for Asset Liability

Management, ideally the Treasurer (or the CEO) is the Chairman of the ALCO

committee. The committee consists of the following key personnel of a bank:

- Chief Executive Officer / Managing Director

- Head of Treasury / Central Accounts Department

- Head of Finance

- Head of Corporate Banking

- Head of Consumer Banking

- Head of Credit

- Chief Operating Officer / Head of Operations

The committee calls for a meeting once every month to set and review strategies on

ALM.

Key Agendas:

ALCO attends the following issues while managing Balance Sheet Risks:

i) Review of actions taken in previous ALCO.

ii) Economic and Market Status and Outlook.

iii) Liquidity Risk related to the Balance Sheet.

iv) Review of the price / interest rate structure.

v) Actions to be taken.

3.2.4 Policy Recognition and Assessment:

An effective internal control system continually recognizes and assesses all of the

material risks that could adversely affect the achievement of the bank’s goals.

Effective risk assessment must identify and consider both internal and external

factors. Internal factors include complexity of the organization structure, the

nature of the Bank’s activities, the quality of personnel, organization changes and

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also employee turnover. External factors include fluctuating economic conditions,

changes in the industry, socio-political realities and technological advances.

Risk assessment by Internal Control System differs from the business risk

management process, which typically focuses more on the review of business

strategies developed to maximize the risk/reward trade-off within the different

areas of the bank. The risk assessment by Internal Control focuses more on

compliance with regulatory requirements, social, ethical and environmental risks

those affect the banking industry.

3.2.5 ALCO Paper:

An ALCO paper is produced every month (usually by the Finance Department) which

covers various issues related to Balance Sheet risk management. The ALCO paper is

prepared before the ALCO meeting as the committee reviews the ALCO paper to set

strategies. An ALCO paper typically covers the following:

3.2.6 The ALCO Process:

The ALCO process or the ALCO meeting reviews the ALCO paper along with the

prescribed agendas. The Chairman of the committee, that is the Treasurer or the CEO,

raises issues related to the balance sheet. Treasurer suggests whether the interest rates

need to be reprised, whether the bank needs deposits or advance growth, whether growth

of deposits and advances should be on short or longer term, what would be the transfer

price of funds among the divisions, what kind of interbank dependency the bank should

have etc. In short, all issues related to liquidity and market risk are covered. Based on the

analysis and views of the Treasurer, the committee takes decisions to reduce balance

sheet risk while maximizing profits.

3.2.7 Action Points:

The ALCO takes decisions for implementation of any/all of the following issues:

Need for appropriate Deposit mobilization or Asset growth in right buckets to

optimize asset-liability mismatch.

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Cash flow (long/short) plan based on market interest rates and liquidity.

Need for change in Fund Transfer Pricing (FTP) &/or customer rates in line with

strategy adapted.

Address to the limits that are in breach (if any) or are in line of breach and

provide detailed plan to bring all limits under control.

Address to all regulatory issues that are under threat to non-compliance.

3.2.8 Special ALCO Meeting:

Apart from the regular monthly meeting, ALCO meeting is also called as and when any

contingent situations arise. A very good example may be, during the Eid period. At those

times, market liquidity dries out and overnight rates shoot up. Banks who are net

borrowers from the market may be exposed to huge interest expense the high rates in the

market. This is an ideal time for a special ALCO meeting, where the committee may take

critical decisions for deposit mobilization on an urgent basis for reducing dependency

from the market.

3.2.9 Control Activities and Segregation of Duties:

Effective internal control system requires that an appropriate control structure is

set up with control activities defined at every business level, i.e. top level review;

appropriate activity controls for different departments or divisions; physical

controls; checks for compliance with exposure limits and follow-up on non-

compliance; a system for approvals and authorizations and system pf verification

and reconciliation.

Control activities involve two steps: (1) the establishment of control policies and

procedures and (2) verification that the control policies and procedures are being

complied with.

Senior management should ensure that adequate control activities are an integral

part of the daily functions of all relevant personnel; this enables quick response to

changing conditions and avoids unnecessary costs. Control activities are most

effective when they are viewed by management and all other personnel as an

integral part of daily activities rather than an addition to it.

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One of the most important aspects of internal control system requires that there is

appropriate segregation of duties and personnel are not assigned conflicting

responsibilities.

Furthermore the employees must also be provided with necessary authority,

which will enforce segregations of duties.

For employees to carry out their responsibilities properly each employee should

have appropriate job description

Areas of potential conflicts of interest should be identified, minimized and subject to

careful independent monitoring

3.2.10 Establishment of a Compliance Culture:

A bank is said to have strong compliance culture when throughout the

organization employees are encouraged to comply with policies, procedures and

regulation. Even an individual at the lowest echelon should be empowered to

speak up without the fear of reprisal if she/he identifies something non-compliant.

The board of directors and the senior management must establish a compliance

culture within the banking organization that emphasizes and demonstrates to all

levels of personnel the importance of internal control.

In order to establish a compliance culture the board of directors and senior

management must promote a high ethical and integrity standard.

In reinforcing ethical values the banking organization should avoid policies and

practices that provide inadvertent incentive for inappropriate activities. Examples

of such policies and practices include undue emphasis on performance targets or

operational results, particularly short term ones that ignore long term risks and

compensation schemes that overly depend on short term performance. The board

of directors and the senior management may establish a ‘Code of Ethics’ that all

levels of personnel must sign and adhere to.

3.3 The policy statement of Asset Liability Management:

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The policy statement of Asset Liability Management is laid out for the followings and

annual review would be carried out taking into the conclusion of changes in Balance

Sheet and market dynamics.

a) Advance Deposit Ratio (AD):

The bank shall maintain Advance deposit ratio in the following manner:

Advance Deposit ratio should be fixed as per guidelines and norms set by the

Central Bank of the country. At present the Advance Deposit ratio is 84 %.

However, the Loan Deposit ratio of the bank should go up to 110% as per

guidelines set in managing core risks in banking, Asset Liability Management.

(ALM)

To calculate the Advance Deposit ratio, The formula given by the Central Bank to

be followed

The Loan Deposit ratio = Loan/(Deposit + Capital + Funded Reserve)

b) Wholesale Borrowing Guidelines (WBG):

To borrow from wholesale market (or inter bank market), the capacity and amount to be

determined considering the following factors.

The size and turnover of the local market; our share of that market

The credit limits imposed by our counter parties.

Beside these, the following factors are also to be considered at the time of fixing the

amount of borrowing.

Balance sheet size of the bank.

Historical trend of market liquidity.

Credit Rating of the bank (to understand counter party banks’ limits on the

concerned bank).

Stability of liquidity and interest rates of the market.

c) Commitments:

A register regarding sanction of loans to be introduced.

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A clause to be inserted in the sanction advice stating the time of taking

disbursement. Failing to avail the loan within disbursement time, loan

automatically cancelled.

During the continuation of time for disbursement, undrawn disbursement amount

to be calculated which will be trend as commitment.

Commitment amount to be considered for raising funds for the bank along with

other factors.

d) Medium Term Funding Ratio (MTF):

Central banks guidelines regarding Medium term Funding (MTF) to be followed.

Medium term funding ratio to be maintain in conformity with Bangladesh banks

directives.

e) Maximum Cumulative Outflow (MCO):

Maximum cumulative out flow to be maintained as per Central bank’s directives and

guidelines.

f) Liquidity Contingency Plan:

Liquidity is to be maintained as per Central Bank’s directives. However, the bank will

place the following percentage of its customer deposits with the central bank.

CRR – 4.5% of average Time and Demand as at two Months prior period (Interest free)

SLR – 13.5% of average Time and Demand deposits as at two months prior period

Foreign currency balance held with central bank will not qualify for CRR.

g) Capital Adequacy Ratio:

The bank will maintain a minimum capital on its risk-weighted assets. At present, the

minimum capital requirement is at 9 %.

End of Chapter 3

CHAPTER 4:EMPIRICAL ANALYSIS OF ASSET LIABILITY MANAGEMENT

IN MUTUAL TRUST BANK LTD.

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4.1 TABULATION AND ANALYSIS OF DATA:

The collected data have been tabulated after collection. Through tabulation data are

condensed into necessary tables. After tabulation data are used for better analysis.

Formula Used in Empirical Analysis of Asset Liability Management:

Total Assets = Total Liabilities + Capital

The Loan Deposit ratio = Loan/(Deposit + Capital + Funded Reserve)

Net interest income (NII) = Interest income – interest Expense

Net interest Margin (NIM) =

Rate sensitive Assets (RSA) = Rate Sensitive Liabilities (RSL)

Interest sensitive gap = interest sensitive assets – interest sensitive liabilities

GAP=RSA- RSL

Relative Gap (RG) =

NW = A – L

Δ NW = ΔA – ΔL

Positive duration gap =Asset duration –Liability duration>0

Negative duration gap =Asset duration –Liability duration<0

% Δ in market value of security = -(% Δ in interest rate)* duration in year.

Interest Sensitivity Ratio =

Landing Deposit Ratio = X 100

Profitability:

Return on Assets (ROA) = Net Income / Assets (NI/A)

Return on Equity (ROE) = Net Income / Equity (NI/E)

Return on Earning Assets (ROEA) = Net Income / Earning Assets (NI/EA)

Return on Loans (ROL) = Interest Income / Loans (II/L)

Interest Income / Earning Assets (II/EA)

Net Interest Income / Earning Assets (NII/EA)

Interest Margin (IM) = Return on Fund - Cost of Fund (IM)

4.2 EMPIRICAL ANALYSIS OF ASSET LIABILITY MANAGEMENT OF

MUTUAL TRUST BANK LTD.

To analyze the asset liability management I have analyzed of a banks Net Interest

Income, Net Interest Margin (Nim), Gap, Duration, Interest Sensitivity Ratio, Liquidity

32


Ratio. And tried to compare with bank’s profitability to find that whether there have any

relations or not.

Analysis is given below:

4.2.2 NET INTEREST INCOME (NII):

We know: Net interest income (NII) = Interest income – Interest Expense

Table I: Net Interest Income (Taka in Million)Year Interest Income (-) Interest Expense NII2008 1686.87 1258.70 430.172007 1139.96 820.68 319.272006 723.09 447.70 245.382005 457.84 330.72 127.12

(Sources: Annual Report of MTBL)

Here NII is increasing day by day because increase in interest rates earned on asset, other

wise increase in interest paid on funding will decrease NII.

4.2.3 NET INTEREST MARGIN (NIM):

We Know: Net interest Margin (NIM) =

Table 2: Net Interest Margin (Taka in Million) Year Net Interest Income Earning Assets NIM 2008 430.17 17419.05 2.46%2007 319.27 14779.16 2.16% 2006 245.38 8300.61 2.95%2005 127.12 5369.61 2.36%

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Here NIM was highest in 2006, after that gone down in 2007 and again increased in

2008. So we can say that NIMs were on an average sequence and ALM is going on

moderate way.

4.2.4 GAP ANALYSIS:

Gap management techniques require management to perform an analysis of the maturities

and re-prising opportunities associated with the bank’s interest sensitive assets, deposits

and money market borrowings. A bank can hedge itself by making sure for each time

period that—

Rate Sensitive Assets (RSA) = Rate Sensitive Liabilities (RSL)

The most familiar example of re-pricing assets is loans that are about to mature or are

coming up for renewal. If interest rate have risen since these loans were first make, the

bank will renew them only if it can get an expected yield that approximates the higher

yields currently expected on other financial instruments of comparable quality. Re-

pricing liabilities include CDs about to mature or be renewed, floating rate deposits, and

money market borrowings.

Interest Sensitive Gap:

A gap exists between these interest sensitive assets and interest sensitive liabilities when

—Interest Sensitive Gap = Interest Sensitive Assets – Interest Sensitive Liabilities.

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If interest sensitive assets in each planning period exceed (= >0) the volume of interest

sensitive liabilities, the bank is said to have a positive gap and to be asset sensitive. In

this situation if interest rate rises, the bank’s net interest margin will increase because the

interest revenues generated by the bank’s assets will increase more than the cost of

borrowed funds and vice-versa. The banks with positive gap will reduce if interest rate

falls. In the opposite situation the bank has a negative gap and is said to be liability

sensitive. Liability sensitive (negative) gap = interest sensitive assets – interest sensitive

liabilities < 0. In that case, rising interest rate will lower the bank’s net interest margin,

because the rising cost associate with interest sensitive liabilities will exceed increase in

interest revenue from the bank’s earning assets and vice-versa. Only if interest sensitive

assets and liabilities are equal is a bank relatively insulated from interest rate risk. As a

practical matter, however, a zero gap does not eliminate all interest rate risk, because the

interest rate attached to bank assets and liabilities are not perfectly correlated in the real

world. Loan interest rate, for example, tends to lag behind interest rates on money market

borrowings. In practical world, zero gaps are also impossible.

4.2.4.1 Maturity Gap:

The total effect of interest rate change can be summarized by its maturity gap, is the

difference between interest Rate Sensitive Assets (RSA) and the interest Rate Sensitive

Liabilities (RSL)

Rate Sensitive Assets (RSA) of the Bank is-

Money call at short notice

Investment (in shares and securities)

Short Term Loan and Advance

Non-Banking Asset

Rate Sensitive Liabilities (RSL) of the Bank is-

Borrowing from other banks, financial institutions and agents

Deposit and other accounts (except fixed deposits)

Total share Holders Equity

4.2.4.2 Gap:35


We know: GAP = RSA – RSL

Table 3: Gap (Taka in Million)Year RSA RSL GAP2008 2420.93 32197.08 -29776.142007 1585.18 26328.25 -24713.062006 739.51 14327.34 -13587.832005 412.54 1036.21 -9903.66


Here gap is negative and this gap has increased year by year, which is not a good sign for

the Bank.

4.2.4.3 Relative Gap:

Relative Gap (RG) =

Table 4: Relative Gap (Taka in Million)Year GAP Total Asset Relative Gap Ratio2008 -29776.14 19306.99 -1.542007 -24713.06 15931.03 -1.552006 -13587.83 9037.53 -1.502006 -9903.66 5832.10 -1.69


36


Here relative gap is negative but has reduced over the time. It is some how good sign that

they tried to cover-up this Gap.

4.2.5 DURATION ANALYSIS:

Duration is a value and time weighted measure of maturity that considers the timing of all

cash flows from earning assets and all cash outflows associated with liabilities. In effect,

duration measures the average time needed to recover the funds committed to an

investment. The net worth (NW) of any bank is equal to the value of its assets (A) less

the value of its liability (L):

NW = A – L

As interest rates changes, the value of both a bank’s assets and liabilities will change,

resulting in a change in net worth:

Δ NW = ΔA – ΔL

Portfolio Theory of Finance Told That –

1. A rise in market rates of interest will cause the market value (price) of both bank

fixed-rate assets and liabilities to decline.

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2. The longer the maturity of a bank’s assets and liabilities, the more they in the

market value (price) when market interest rates rise.

Duration analysis can be used to stabilize the market value of a bank’s net worth (NW). It

measures the sensitivity of the market value of financial instruments to changes in

interest rates. The interest rate risk of financial instruments is directly proportional to

their duration.

Positive Duration Gap = Asset Duration – Liability Duration > 0

Negative Duration Gap = Asset Duration – Liability Duration < 0

With liability having a longer duration than the bank’s assets, a parallel change in all

interest rates will generate a larger change in liability values than assets values. If interest

rates fall, the bank’s liabilities will increase more in value than its assets and net worth

will decline. If interest rates rise, however, liability values will decrease faster than assets

value and bank’s net worth position will increases in value.

This method of measuring interest rate risk examines the sensitivity of the market value

of the bank’s total assets and liabilities to changes interest rates. Duration is a useful

concept because it provides a good approximation of the sensitivity of a security’s market

value to a change in its interest rates.

% Δ in Market Value of Security = - (% Δ in Interest Rate)* Duration in Year.

Duration analysis involves comparing the average duration of the bank’s assets to the

average duration of its liabilities. Let us suppose that the average duration of HYPO

BANK’S assets is 5 years, while the average duration of its liabilities is 3years. With a

5% increase in interest rates, the market value of the bank’s assets fall by 25% = (5%*5

years) and the market value of the liabilities declined by 15%(= - 5%*3 years). The net

result is that the net worth has declined by 10% of the total asset value.

The interest sensitive gap is interest sensitive assets minus the interest sensitive liabilities,

where interest sensitive assets and liabilities are those items on a bank’s balance sheet

that mature or whose interest rate can be changed during a given interval of time. A bank,

which is asset sensitive, will suffer a decline in its net interest margin if market interest

38


rates fall. A bank that is liability sensitive will experience decrease in its met margin if

interest rates rise. One of the most popular methods of neutralizing these gap risks is to

buy or sell financial futures contracts. A financial futures contract is an agreement

between a buyer and a seller reached today that call for the delivery of a particular

security in exchange for cash at some future date. The market of futures contract changes

daily as the market price of the security to be exchanged moves over time.

The financial futures market are designed to shift the risk of interest rate fluctuations

from risk averse investors, such as commercial bank, to speculators willing to accept and

possibly profit from such risks. When a bank contracts an exchange broker and offers to

sell futures contract, this means it is promising to deliver securities of a certain kind and

quality to the buyer of those contracts on a stipulated date at predetermined price.

Conversely, a bank may enter the future markets as a buyer of futures contracts, agreeing

to accept delivery of a particular security named in each contract or to pay cash to the

exchange-clearing house the day the contacts mature, based on their price at that time.

A futures hedge against interest rate changes generally requires a bank to take an opposite

position in the futures market from its current position in the cash market. Thus, a bank

planning to buy bond contracts (go long) in the cash market today may try o to protect the

bonds’ value by selling bond contracts (go short) in the futures market. Then, if bond

prices fall in the cash market there will bean offsetting profit in the futures market,

minimizing the loss due to changing interest rates.

4.2.6 INTEREST SENSITIVITY RATIO:

Interest Sensitivity Ratio =

Table 5: Interest Sensitivity Ration (Taka in Million)Year RSA RSL ISR2008 2420.93 32197.08 0.0752007 1585.18 26328.25 0.060

39


2006 739.51 14327.34 0.0502005 412.54 1036.21 0.039

(Source Annual Report of MTBL)

Here is seen interest sensitivity ratio is always less than 1,

A financial institution at a given time asset or liability sensitive, If the financial

institution is asset sensitive it will be positive gap, Positive relative gap, Interest

sensitivity ratio is greater than 1. If financial institution is liability sensitive it will be

negative gap, negative relative gap, and interest sensitivity ratio is less than 1.

Here in Mutual Trust Bank Gap is Negative, relative Gap is Negative; Interest Sensitivity

Ratio is less than 1.

So it is a Liability Sensitive Financial Institution.

4.2.6 LIQUIDITY RATIO:

Landing Deposit Ratio = X 100

Table Six: Liquidity Ratio (Taka in Million)Year Loan Deposit LD Ratio2008 14373.26 16098.54 89.28%2007 11692.97 13164.13 88.82%2006 5904.18 7163.67 82.42%2005 3437.13 5158.11 66.64%


40


Liquidity Ratio should be 80% to 85% for a Bank. But here is 64% to 89%. So we can

say that they can use their deposits bitterly to earn more profit.

4.3 FINDINGS OF ASSET /LIABILITY MANAGEMENT (ALM):

Here NII is increasing day by day because increase in interest rates earned on

asset, otherwise. Increase in interest paid on funding will decrease NII.

NIM is here is similar sequence up to 2% that ALM is going on Moderately.

Here Gap is negative

Here Relative Gap is also negative

Here is seen Interest sensitivity ratio is always less than 1,

Liquidity Ratio should be 80% to 85% for a Bank. But here is 64% to 89%. So

we can say that they can use their deposits bitterly to earn more profit.

A financial institution at a given time asset or liability sensitive, if the financial institution

is asset sensitive it will be positive gap, positive relative gap, interest sensitivity ratio is

greater than 1. If financial institution is liability sensitive it will be negative gap, negative

relative gap, and interest sensitivity ratio is less than 1.

Here in Mutual Trust Bank Gap is Negative, relative Gap is Negative; Interest

Sensitivity Ratio is less than 1. So it is a Liability Sensitive Financial Institution.

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4.4 LIABILITY MANAGEMENT AND ITS IMPACT ON PROFITABILITY:

It is already mentioned that effective liability management depends on less cost and less

volatile fund. It also depends on the effective utilization of the collected funds. From the

analysis, it is already clear that current deposit is the least costly source of deposited

funds whereas fixed deposit is the most costly source of deposited funds. But current

deposit is the most volatile sources in nature and fixed deposit is the stable nature. Term

deposit is consists of savings and fixed deposit. So, for getting an appropriate liability

structure, bank management must make a balance between current and term deposit. It

can also use money market borrowing because it is less costly and flexible compared to

deposit. A bank can also rely on various off-balance sheet items for funding to its needs.

Liability management also depends on the effective use of the collected funds. Improper

use makes the collected funds burden for the bank. In this part, various ratios are

analyzed both in the context of interest cost of the funds and their effective utilization.

Profitability Ratios of Mutual Trust Bank Limited:

Ratios 2008 2007 2006 2005Return on Assets (ROA) 1.74 1.55 2.106 1.68

Return on Equity (ROE) 21.72 20.30 19.61 30.74

Operating Profit Margin 19.90 21.68 26.32 21.51

Net Interest Margin (NIM) 2.47 2.16 2.95 2.37

Net Profit (tk in Million) 336.17 247.19 259.23 187.52

Earnings per Shares (tk) 21.07 14.80 16.12 12.38

Price Earning Ratio (Times) 15.18 40.30 14.32 12.56

The value of ROA and ROE depends on the volume of net income after tax. So, if banks use

heavily deposits, especially term deposits as sources of fund then ultimately the interest cost will

be increased. As a result values of the mentioned ratios will be decreased.

The value of ROA has decreasing trend. The ROA of Mutual Trust Bank Ltd. is growing

over the first two years. After 2006 it has increased again. It indicates that the

management is somehow able to achieve consistent growth in the bank’s spread through

close control over the bank’s earning assets and the pursuit of the cheapest sources of

funding.

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If we see only net interest margin (NIM) then the impact of liability management can be

realized directly. Because interest expense depends on liability portion but the income

portion depends on how one can utilize the funds in an efficient and profitable way. In

this case the ratio of net non-interest margin and net operating margin can explain the

impact of liability on profitability.

The vulnerable trend of Earning Spread of Mutual Trust Bank Ltd. reflects the low

efficiency of its intermediation functions and its strong position in the competition. A

liability structure will be effective only if the bank can earn profit by using it. And the

liability will give profit only if it is stable and less costly. In all respect Mutual Trust

Bank failed to manage its liability. As Mutual Trust Bank is a service oriented private

bank, it cannot say no to the public regarding the acceptance of deposits. The bank has to

accept a huge amount of term loan every year. But it does not have the much opportunity

to invest those loans. The bank is suffering from bad loans. So, interest revenue from the

earning assets is becoming due in every year. It affects the bank’s net interest margin. In

case of investment, Mutual Trust bank invested majority of its funds to advances. It

enhances the default risk. The next major portion in the use of fund is money market

lending sector. The bank also has to maintain the required provision for classified loans

that places an adverse impact on the profit as well as on the capital of the bank.

End of Chapter 4

CHAPTER 5

SUMMARY AND CONCLUSION

5.1 SUMMARY:

There is no disagreement that the performance of the commercial banks of a country

should be judged in the context of the objectives of development and socio-economic

conditions prevailing in that country. At the same time, the question of cost effectiveness

of the operation of the commercial banks should also be given due weightage. A bank

43


will be cost effective, if it can collect low cost and less volatile funds and can effectively

invest it in profitable secretors. For achieving the objective of cost effectiveness the

banks should perform proper asset liability management.

Banking has started with asset liability management. Like other financial intermediaries,

commercial banks also intermediate between the savers and the borrower, to mobilize the

financial surpluses of the savers and allocate these savings to the credit-worthy borrowers

of different sectors in the economy. In this way, they not only help in the financial

development of a country, but also facilitate the economic development. By doing this

intermediation function, commercial banks are creating liability for the banks.

Commercial banks are financial intermediaries who mobilize funds from surplus

economic units and deploying these funds to deficit economic units. At the very

beginning of the commencement of the business, commercial banks need funds for its

survival. They collect funds and the again lend these funds to deficit spenders. By this

way they are making profit.

Banks profit is the difference between revenues earned form the lending to the deficit

units and interest expense to the surplus unit. Banks can collect its funds from mainly

three sources- from public as deposit, from money market borrowing and from off

balance sheet sources. Among the sources, deposit source is the most costly but captures

almost eighty percent share in the liability portfolio. Again deposit can be divided into

three types – current deposit, savings deposit and fixed deposit. Current deposit is the

least costly funds of the bank. No interest cost is involved in that fund. It is generally kept

by businessmen. Some administrative cost is involved in current deposit. But the problem

is that current deposit is the most volatile deposit among the deposit portfolio. Banks are

bound to refund the funds when claims are raised from depositors. It is against the

principle of stability in liability management. If current deposit has the large portion in

the deposit portfolio, then the bank cannot afford to go for long-term investment. Because

in these cases banks may face liquidity crisis.

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Savings and fixed deposits are the costly sources of funds for a bank. These funds are

relatively stable in nature. If bank has large portion of fixed deposit in the liability

portfolio, then the bank has to incur a large volume of interest expense.

Banks can also collect its necessary funds from the money market. Money market is an

arrangement where the banks lend its surplus cash to other banks that need funds. The

money market interest rate is generally lower than the deposit interest rate. If there is a

strong money market in the economy, it reduces the dependency of bank on the costly

source of fund, i.e. deposits. Commercial banks can borrow from the money market as

and when required.

Another important source of bank funds, which is very much popular in developed world,

is the off-balance sheet source. They arte asset securitization, loan selling, financial

futures, interest rate options and interest rate swaps. But in our country only the

traditional off-balance sheet items such as letters of credit, letter of guarantee, and bills

for collection constitute an important element in the liability structure of most of the

banks. Interest cost does not involve in case of off-balance sheet items. Only some

administrative cost such as telephone, telegrams and stamps are involved here.

When analyzing the annual report of the sampled banks, it is found that for all the banks

deposit has the major contribution in the liability portfolio. The next share is for the off-

balance sheet activities and money market borrowing respectively.

The following findings are mention worthy—

1. Mutual Trust Bank limited, representative of commercial banks in the study, it is a

Liability Sensitive Financial Institution. The liability structure of the Mutual Trust Bank

is not appropriate. The bank fails to make balance between less costly and stable funds. It

has a greater amount of term deposit, which is costly. Besides the decreasing trend of

current deposit made the cost of fund high.

45


2. Beside interest cost, there must have some other reason that is manpower productivity

that contributes to the profitability of Mutual Trust Bank. It means that other than interest

cost, some variables has strong influence on the profitability of the bank, which is not a

normal phenomena. The amount of non-interest expense of the bank is high. It indicates

misuse of money.

3. Effective liability management also depends of the effective use of the collected funds.

Mutual Trust bank invested most of its funds in advances. But the problem of the bank is

the huge amount of classified advances. In 2007, 45.32% of total advances were

classified. It places an adverse pressure on the profit potential of the bank. Besides, the

bank has to pay interest on the funds collected for funding these advances. But the bank

is getting no return on these advances. This made the situation for the bank unfortunate.

4. Newly established private commercial banks are giving attention to liability

management in the context of effective utilization of the collected funds. But they have

also failed to maintain a balance between less costly funds and less volatile funds.

5. About 80%of total deposits of Mutual Trust bank are term deposit. It means that it fails

to maintain balance between demand deposit and term deposit. But the bank is successful

in proper utilization of its collected funds. It makes the bank profitable. But the bank

could have enhanced its profit if it could make a balance between less costly funds.

6. The bank is investing majority of its funds in advances. In 2007, 2.04% of total

advances were classified. It indicates proper utilization of the collected funds. In this

context, it can be said that the bank is successful in managing its liability.

5.2 CONCLUSION WITH RECOMMENDATION:

On the basis of the findings, the following actions are recommended—

1. Mutual Trust bank should have a strong Asset-Liability Management Committee

(ALCO) which will develop investment policy guidelines, develop the desired risk-return

trade-off, will give decision regarding which types of deposit will be accepted and which

type of assets will be financed by which type of liability.

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2. Mutual Trust bank should have a clear ALM Policy. In the study it is found that

Mutual Trust is utilizing their collected funds properly. Improper use of funds will

increase the cost of the liability. Again a bank can make profit even by accepting funds at

high cost if it can use the funds properly.

3. The non-interest expense of the bank should be reduced.

4. The bank should accept funds according to the potentiality of investing them. If a bank

cannot invest its funds, it will increase the real cost of the fund.

Strong Money Market should be developed in this country. If strong money market is

developed, then a bank can borrow funds from the market as and when required. It will

reduce the dependency of the bank on the deposit. As the money market borrowing is less

costly compared to deposited funds, it will reduce the bank’s cost of fund.

5. Mutual Trust Bank should go for new off-balance sheet sources for getting the required

funds. It can securitize its assets when it needs funds. Again it can sell the loan to other

banks when funds are needed. Other off-balance sheet sources can be used according to

their nature.

6. Bank should invest a significant amount in human resources development so that they

can form strong human capitals that ultimately contribute to ensure profitability in future.

7. Bank should invest a significant amount in research and developments so that it can

identify the appropriate source of funned according to the nature of investment.

8. Bank should have a strong monitoring cell so that the investment can not be a bad one.

In this respect, the cell can give advice to the borrower in technical, financial and other

related issues that will ensure the efficient use of funds by the borrower.

9. Mutual Trust Bank should give its customer a greater amount of ancillary service. No

funds are involved in providing ancillary services. It will reduce the dependency of the

bank on funds, which in turn will increase the fee earnings of the bank.

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10. Government must take necessary steps in the development of strong money market in

the country.

Bibliography

Web search: Mutual Trust Bank Limited

Web Search: Asset Liability Management

Annual Report of MTBL (2005 to 2008)

Book:

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1. Commercial Banking, The Management of Risks, Gup & kolari, 3rd Edition.

2. Bank Management & Financial Service, Peter. S. Rose Sylviac. Hudgins, 6th Edition

End of Chapter 5

49

Mba Project

Documents

management of asset

banks liability

effective liability

liability management

foal of liability management

liability of mutual

asset management deals

sample bank