Study of asset liability management in Indian

banks.
Introduction

Asset Liability Management (ALM) defines management of all assets and

liabilities (both off and on balance sheet items) of a bank. It requires assessment
of various types of risks and altering the asset liability portfolio to manage risk.
Till the early 1990s, the RBI did the real banking business and commercial banks
were mere executors of what RBI decided. But now, BIS is standardizing the
practices of banks across the globe and India is part of this process. The success
of ALM, Risk Management and Basel Accord introduced by BIS depends on the
efficiency of the management of assets and liabilities. Hence these days without
proper management of assets and liabilities, the survival is at stake. A bank’s
liabilities include deposits, borrowings and capital. On the other side pf the
balance sheets are assets which are loans of various types which banks make to
the customer for various purposes. To view the two sides of banks’ balance
sheet as completely integrated units has an intuitive appeal. But the nature,
profitability and risk of constituents of both sides
should be similar. The structure of banks’. balance sheet has direct implications
on profitability of banks especially in terms of Net Interest Margin (NIM). So it is
absolute necessary to maintain compatible asset-liability structure to maintain
liquidity, improve profitability and manage risk under acceptable limits.
ALM MODELS

Analytical models are very important for ALM analysis and scientific decision
making. The basic models are:

1. GAP Analysis Model

2. Duration GAP Analysis Model
3. Scenario Analysis Model
4. Value at Risk (VaR) model
5. Stochastic Programming Model

Any of these models is being used by banks through their Asset Liability
Management Committee (ALCO). The Executive Director and other vital
departments’ heads head ALCO in banks. There are minimum four members and
maximum eight members. It is responsible for Responsible for Setting business
policies and strategies, Pricing assets and liabilities, Measuring risk, Periodic
review, Discussing new products and Reporting.
OBJECTIVES OF THE STUDY
Though Basel Capital Accord and subsequent RBI guidelines have given a
structure for ALM in banks, the Indian Banking system has not enforced the
guidelines in total. The banks have
formed ALCO as per the guidelines; but they rarely meet to take decisions.
Public Sector banks are yet to collect 100% of ALM data because of lack of
computerization in all branches. With this background, this research aims to find
out the status of Asset Liability Management across all commercial banks in India
with the help of multivariate technique of canonical correlation. The discussion
paper has following objectives to explore:

• To study the Portfolio-Matching behavior of Indian Banks in terms of nature and

strengths of relationship between Assets and Liability
• To find out the component of Assets explaining variance in Liability and
viceversa
• To study the impact of ownership over Asset Liability management in Banks
• To study impact of ALM on the profitability of different bank-groups
METHODOLOGY
The study covers all scheduled commercial banks except the RRBs (Regional
Rural Banks).
The period of the study was from 1992 – 2004. The banks were grouped based
on ownership structure. The groups were

1. Nationalized Banks except SBI & Associates ( 19 )

2. SBI and Associates ( 8)
3. Private Banks( 30)
4. Foreign Banks(36)
RECLASSIFICATION OF ASSETS &
LIABILITIES
The assets and liabilities of a Bank are divided into various sub heads. For the
purpose of the study, the assets were regrouped under six major heads and the
liabilities were regrouped under four major heads as shown in table below. This
classification is guided by prior information on the liquidity-return profile of assets
and the maturity-cost profile of liabilities. The reclassified assets and liabilities
covered in the study exclude ‘other assets’ on the asset side and ‘other liabilities’
on the liabilities side. This is necessary to deal with the problem of singularity
– a situation that produces perfect correlation within sets and makes correlation
between sets meaningless. The relevant data has been collected from the RBI
website.
CANONICAL CORRELATION ANALYSIS

Multivariate statistical technique, canonical correlation has been used to access

the nature and strength of relationship between the assets and liabilities. To
explore the relationship between assets and liabilities, we could merely compute
the correlation between each set of assets and each set of liabilities.
Unfortunately, all of these correlations assess the same hypothesis - that assets
influence liabilities. Hence, a Bonferroni adjustment needs to be applied. That is,
we should divide the level of significance by the number of correlations. This
Bonferroni adjustment, of course, reduces the power of each correlation and thus
can obscure the findings. Canonical correlation provides a means to explore all
of the correlations concurrently andthus obviates the need to incorporate a
Bonferroni adjustment. The technique reduces the relationship into a few
significant relationships.The essence of canonical correlation Measures the
strength of relationship between two sets of variables (Assets (6) & Liabilities (4)
in this case) by establishing linear combination of variables in one set and a
linear combinations of variables in other set. It produces an output that shows the
strength of relationship between two variates as well as individual variables
accounting for variance in other set
.
A = A1 * (Liquid Assets) + A2 * (SLR Securities)+ A3 * (Investments) + A4 *
(Term Loans) + A5 *
(Short Term Loans) + A6 * (Fixed Assets)
B = B1 * (Net Worth) + B2* (Borrowings) + B3 *(Short Term Deposits) + B4 *
(Long Term Deposits)
To begin with, A and B (called canonicalvariates) are unknown. The technique
tries to compute the values of Ai and Bi such that the covariance between A & B
is maximum.
 Foreign Banks Pvt Banks Nationalised SBI &
Banks Associates
R square 0.948 0.997 0.987 0.998
Canonical
Loadings
Assets
LA 0.243 0.716 -0.046 0.237
SLR 0.078 0.712 -0.328 0.744
INV 0.314 -0.467 -0.662 0.858
TL -0.469 -0.464 0.188 0.568
STL 0.268 0.461 0.747 -0.88
FA -0.903 -0.945 -0.728 0.644
Liabilities
NW -0.664 -0.948 -0.885 0.831
BOR 0.171 -0.523 0.593 -0.83
STD 0.498 0.972 0.126 -0.457
LTD -0.255 -0.201 0.007 0.964

Redundancy
Asset 0.212 0.426 0.279 0.476
Liability 0.196 0.539 0.288 0.629

The first row (R2) is a measure of the significance of the correlation. In this case
all the correlations are significant. The canonical loading is a measure of the
strength of the association i.e. it is the percent of variance linearly shared by an
original variable with one of the canonical variates. A loading greater that 40% is
assumed to be significant. A negative loading indicates an inverse relationship.
For example, for Foreign Banks, Fixed Assets (FA) under Assets has a loading of
-0.903 and Net Worth (NW) under liabilities has a loading of
-0.664. Since both are negative this means there is a strong correlation between
FA and NW. Similarly for Foreign Banks, we can observe that there is a strong
negative correlation betweenshort term deposit with both Term Loan and Fixed
Asset.
OBSERVATIONS
As per the summary table above, the canonical co-relation coefficients of
different set of banks indicate that different banks have different degree of
association among constituents of assets and liabilities. Bank-Groups can be
arranged in decreasing order of correlation:
– SBI & Associates
– Private Banks
– Nationalized Banks
– Foreign Banks
Redundancy factors indicate how redundant oneset of variables is, given the
other set of variable which gives an idea about independent anddependent sets.
This also gives an idea aboutthe fact that whether the bank is assetmanaged or
liability managed. Looking at the redundancy factors, the independent and
dependent sets for different bank- groups can beidentified:
Other than foreign bank groups, all other three have asset as their independent
set. This means during the study period (1992-2004), these banks were actively
managing assets and liability was dependent upon how well the assets are
managed. This is in perfect consonance with the macro indicators. The interest
rates were coming down all these years and banks were busy in parking their
assets in different avenues where they could get maximum return. Lately, the
scenario has changed in terms of interest rates. Now as there is ample liquidity in
the market, banks especially the bigger one is not concerned about the liability.
They can always borrow from active money market to manage their liability.

Foreign Banks
The canonical function coefficient or the canonical weight of different constituents
in case of foreign banks Term Loans and Fixed Assets form asset side and Net
Worth and Short Term Deposit from liability side have significant presence with
following interpretation:
• Very strong co-relation between Fixed Assetand Net Worth.
• Strong negative correlation between short term deposit with both Term Loan
and Fixed Asset. This indicates-
• Proper usage of short term deposit.
• Not used for long term assets or long term loans.

Private Banks
In case of private banks all constituents of asset side Liquid Assets, SLR
Securities, Short Term Loans, Investments, Term Loans, and Fixed Asset are
significantly explaining the co-relation while on liability side only Net Worth and
Short Term Deposit are contributing. This shows how actively these banks
manage their asset to generate maximum return. This relationship can
be interpreted in the following ways:
• Very strong co-relation between FA and NW.
• Short Term Deposits is used for Liquid Assets, SLR and Short Term Loans. As
defined above LA, SLR and STL – all are highly liquid section of assets. So it is
very prudent to employ short term deposit.
• Borrowings are used for Investment and Term Loans. As defined, borrowings
are near maturity liability while investment and term loans are of long term
maturity. So the private banks are using risky strategy of deploying short term
fund in long term investment which is clearly against right
asset-liability management. Under normal circumstances long term investment
gives better returns, so this strategy is to generate additional profitability at the
cost of liquidity. However as the money market has become more matured, it is
easy to manage liquidity without much of risk.

Nationalized Banks
In case of nationalized banks Investment, short term loan, fixed asset contribute
significantly in explaining asset part while net worth and borrowings constituent of
liability is major factor.
The major interpretations are:
• Very strong co-relation between FA and NW.
• Nationalized banks use Borrowings for Short Term Loans.
• There is negative co-relation between Borrowings and investment.
• More concerned with liquidity than profitability
• Conservative strategy ( in comparison toPrivate Banks)
• Good short term maturity/liquidity management

Nationalized banks use a borrowing (which is near term maturity) for short term a
loan which is effective way of ALM. However nationalized banks deploy long term
liability in short term assets. This is distinctly different from private banks
strategy. The nationalized banks are more concerned about liquidity than
profitability.

SBI & Associates

For SBI group all constituents of Liability namely Net worth, borrowings, short
term deposits and long term deposits are significant while in assets side SLR
investment, Investments, Term loans and fixed assets are significant. Following
can be interpreted:
• Very strong correlation between FA and NW
• Strong correlation between Borrowings and STL.
• Correlation between Long term Deposits and ‘Term Loans, Investment and
SLR’.
• Short Term Deposits and Short Term Liabilities are correlated.
• Most Conservative strategy
• Over concerned with liquidity
• Use Long term funds for Long as well as
medium & short term loans Among all bank-groups, SBI & Associates seem to be
most prudent asset liability management as short term liability is matched with
short term asset and long term assets is matched with long term liability. But at
the same time, this group deploy long term fund for medium and short term
loans. This can be called over concerned with liquidity and that too by paying a
price in terms of less profitability by foregoing the opportunity to deploy them in
long term assets.

PROFITABILITY ANALYSIS OF BANKS

As discussed above, private banks are more aggressive in managing their
portfolio for better profit realization. So let us look into the profitability of these
banks and relate that to their ALM. For this all banks are divided into two groups-
Public and Private. Nationalized along with SBI are clubbed together as public
banks while foreign and private banks are clubbed together as private banks.
The profit figures can be compared in terms of Net Profit Margin, Return on Net
Worth and Equity Multiplier. Following graph depicts the comparison The above
comparison shows that till 2002, private banks were better in terms of profitability
indicators. The aggressive strategy adopted by them in terms of deploying asset
for long term is being reflected in the better profitability as compared to public
sector banks. Since 2002, the public banks have caught up with private banks.
This can be due to second generation banking reforms, deregulation and more
autonomy given to the banks in terms of directed credit and regulated interest
rates.

NET PROFIT MARGIN (%)

16

14

12

10
Public
8
Private
6

0
1996

1997

1999

2001

2002

2004
1995

1998

2000

2003

RETURN ON NET WORTH (%)

30

25

20
Public
15
Private
10

0
1996

1997

1999

2001

2002

2004
1995

1998

2000

2003