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Asset Liability Management

Asset Liability Management ALM is a comprehensive and dynamic framework for measuring, monitoring and managing the market risk of a bank. It is the management of structure of balance sheet (liabilities and assets) in such a way that the net earnings from interest is maximized within the overall risk-preference (present and future) of the institutions. In banking, asset and liability management is the practice of managing risks that arise due to mismatches between the assets and liabilities (debts and assets) of the bank. Banks face several risks such as the liquidity risk, interest rate risk, credit risk and operational risk. Asset Liability Management (ALM) is a strategic management tool to manage interest rate risk and liquidity risk faced by banks, other financial services companies and corporations. Banks manage the risks of Asset liability mismatch by matching the assets and liabilities according to the maturity pattern or the matching the duration, by hedging and by securitization. Much of the techniques for hedging stem from the delta hedging concepts introduced in the Black-Scholes model and in the work of Robert C. Merton and Robert A. Jarrow. The early origins of asset and liability management date to the high interest rate periods of 1975-6 and the late 1970s and early 1980s in the United States. Van Deventer, Imai and Mesler (2004), chapter 2, outline this history in detail. Modern risk management now takes place from an integrated approach to enterprise risk management that reflects the fact that interest rate risk, credit risk,

Asset Liability Management

market risk, and liquidity risk are all interrelated. The Jarrow-Turnbull model is an example of a risk management methodology that integrates default and random interest rates. The earliest work in this regard was done by Robert C. Merton. Increasing integrated risk management is done on a full mark to market basis rather than the accounting basis that was at the heart of the first interest rate sensivity gap and duration calculations


Asset Liability Management


Asset Liability Management (ALM) as a concept is gradually gaining currency in Indian conditions in the wake of the on-going financial sector reforms, particularly reforms relating to interest rate deregulation. The technique of managing both Assets and liabilities together has come into being as a strategic response of banks to inflationary pressure, volatility in interest rates and severe recessionary trends which marked the global economy in the 70s and 80s . There are three distinct phases of the evolution of the concept. While the First phase witnessed the advent of highly volatile global financial environment in the 70s the second phase was marked by the explosive growth of new financial products leading the banks in developed economies to focus on liability management and spread management .In the decade to follow , due to new regulatory standards, better internal policy development and rapid advancement in information technology , the Experimentations of last 2/3 decades have converged into comprehensive technique of managing entire bank balance sheet in a cohesive manner , which later came to be known as Asset-Liability management . Although the process is too complex to practice, it is perhaps the only solution for banks to survive in dynamic environment which requires to stress on total balance sheet management.


Asset Liability Management

THREE PILLARS OF ALM ALM process rests on three pillars:

1. ALM information systems => Management Information System => Information availability, accuracy, adequacy and expediency

2. ALM organization => Structure and responsibilities => Level of top management involvement

3. ALM process => Risk parameters => Risk identification => Risk measurement => Risk management => Risk policies and tolerance levels.


Asset Liability Management


The ALM functions extend to liquidly risk management, management of market risk, trading risk management, funding and capital planning and profit planning and growth projection. A sound ALM system should focus on: 1. review of interest rate outlook 2. fixation of interest/ product pricing on both asset and liabilities 3. examining loan portfolio 4. examining investment portfolio 5. measuring foreign exchange risk and 6. managing liquidity risk 7. Review of actual performance vis--vis projections in respect of net profit, interest spread and other balance sheet ratio. 8. budgeting and strategic planning 9. Examining the profitability of new products. Since management of risk is fundamental to sound banking practice, no bank can afford to err on this count. If poorly managed, a bank can experience earning, liquidity and ultimately capital adequacy problem.


Asset Liability Management

Hence the primary objective of the asset liability management is not to eliminate risk; but to manage it in such a way that the volatility of net interest income is minimized in the short term horizon and net economic value of the organization is protected in long term horizon. Broadly the objectives would include controlling the volatility of net income, net interest margin, capital adequacy, liquidity risk and finally ensuring an acceptable balance between profitability growth and risk.


Asset Liability Management


With the onset of financial sector reforms and the liberalization process growing from strength to strength, Indian banks are now being more and more exposed to uncertainty. Under the protective wings of administered framework of yesteryears , hardly, was it necessary to monitor spread as interest on both assets and liabilities side were as per the guidelines of RBI . So also the sourcing and funding pattern which was equally subjected to control leaving insignificantly narrow space for the management to use its discretion. However, things have changed too rapidly since 1991. As the veil of regulations gradually giving into the more autonomous system, post reform banking scenario is marked by 1. Partial deregulation of deposit rates in a phased manner and with rapid frequency 2. Freeing interest rate on lending over Rs.2 lacs 3. Allowing new players in the market 4. Introduction of new products in the market 5. Greater use of information technology with increasing MIS capability. All these developments have increased the volatility of the market in so far as the movement of funds from one segment of the market to another is concerned. Besides the trend towards greater integration of money market, foreign exchange market and capital market is more visible. With the emergence of an active debt market, the volatility in the market condition is expected to be further accentuated.

Asset Liability Management

In this changing scenario where risks and opportunities are plenty, banks can no longer ignore to examine their competitive ability to emerge as active players in market. Besides, Indian banks are under compulsion to take active interest in the market development as a matter of survival. Public sector banks, more conspicuous by their inherent organizational and systematic deficiencies are more under pressure to adopt the new technique of better asset liability management as a strategic response to the increasing trends towards globalised competition.

BENEFTS OF ALM It is a tool that enables bank managements to take business decisions in a more informed framework with an eye on the risks that bank is exposed to. It is an integrated approach to financial management, requiring simultaneous decisions about the types of amounts of financial assets and liabilities - both mix and volume - with the complexities of the financial markets in which the institution operates.


Asset Liability Management

MATURITY BUCKETS Maturity buckets are different time intervals. All Assets & Liabilities to be reported as per their maturity profile into 8 maturity Buckets: i. ii. iii. iv. v. vi. vii. viii. ix. 1 to 14 days 15 to 28 days 29 days and up to 3 months Over 3 months and up to 6 months Over 6 months and up to 1 year Over 1 year and up to 3 years Over 3 years and up to 5 years Over 5 years In which the value of a particular asset or liability is placed depending upon its residual maturity.


Asset Liability Management


ALM ORGANISATION IN BANKS o Successful implementation of the risk management process would require strong commitment on the part of the senior management in the bank, to integrate basic operations and strategic decision making with risk management. The Board should have overall responsibility for management of risks and should decide the risk management policy of the bank and set limits for liquidity, interest rate, foreign exchange and equity price risks. o The Asset - Liability Committee (ALCO) consisting of the bank's senior management including CEO should be responsible for ensuring adherence to the limits set by the Board as well as for deciding the business strategy of the bank (on the assets and liabilities sides) in line with the bank's budget and decided risk management objectives. o The ALM Support Groups consisting of operating staff should be responsible for analyzing, monitoring and reporting the risk profiles to the ALCO. The staff should also prepare forecasts (simulations) showing the effects of various possible changes in market conditions related to the balance sheet and recommend the action needed to adhere to bank's internal limits. o The ALCO is a decision making unit responsible for balance sheet planning from risk -return perspective including the strategic management of interest rate and liquidity risks. Each bank will have to decide on the role of its ALCO, its responsibility as also the decisions to be taken by it. The business and risk

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management strategy of the bank should ensure that the bank operates within the limits / parameters set by the Board. o The business issues that an ALCO would consider, inter alia, will include product pricing for deposits and advances, desired maturity profile and mix of the incremental assets and liabilities, etc. In addition to monitoring the risk levels of the bank, the ALCO should review the results of and progress in implementation of the decisions made in the previous meetings. o The ALCO would also articulate the current interest rate view of the bank and base its decisions for future business strategy on this view. In respect of the funding policy, for instance, its responsibility would be to decide on source and mix of liabilities or sale of assets. Towards this end, it will have to develop a view on future direction of interest rate movements and decide on funding mixes between fixed vs. floating rate funds, wholesale vs. retail deposits, money market vs. capital market funding, domestic vs. foreign currency funding, etc. Individual banks will have to decide the frequency for holding their ALCO meetings.

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Traditionally, banks and insurance companies used accrual system of accounting for all their assets and liabilities. They would take on liabilities - such as deposits, life insurance policies or annuities. They would then invest the proceeds from these liabilities in assets such as loans, bonds or real estate. All these assets and liabilities were held at book value. Doing so disguised possible risks arising from how the assets and liabilities were structured. Consider a bank that borrows 1 Crore (100 Lakhs) at 6 % for a year and lends the same money at 7 % to a highly rated borrower for 5 years. The net transaction appears profitable-the bank is earning a 100 basis point spread - but it entails considerable risk. At the end of a year, the bank will have to find new financing for the loan, which will have 4 more years before it matures. If interest rates have risen, the bank may have to pay a higher rate of interest on the new financing than the fixed 7 % it is earning on its loan. Suppose, at the end of a year, an applicable 4-year interest rate is 8 %. The bank is in serious trouble. It is going to earn 7 % on its loan but would have to pay 8 % on its financing. Accrual accounting does not recognize this problem. Based upon accrual accounting, the bank would earn Rs 100,000 in the first year although in the preceding years it is going to incur a loss. The problem in this example was caused by a mismatch between assets and liabilities. Prior to the 1970's, such mismatches tended not to be a significant problem. Interest rates in developed countries experienced only modest fluctuations, so losses due to asset-liability mismatches were small or trivial. Many firms intentionally mismatched their balance sheets and as yield curves were
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generally upward sloping, banks could earn a spread by borrowing short and lending long. Things started to change in the 1970s, which ushered in a period of volatile interest rates that continued till the early 1980s. US regulations which had capped the interest rates so that banks could pay depositors, was abandoned which led to a migration of dollar deposit overseas. Managers of many firms, who were accustomed to thinking in terms of accrual accounting, were slow to recognize this emerging risk. Some firms suffered staggering losses. Because the firms used accrual accounting, it resulted in more of crippled balance sheets than bankruptcies. Firms had no options but to accrue the losses over a subsequent period of 5 to 10 years. One example, which drew attention, was that of US mutual life insurance company "The Equitable." During the early 1980s, as the USD yield curve was inverted with short-term interest rates sky rocketing, the company sold a number of long-term Guaranteed Interest Contracts (GICs) guaranteeing rates of around 16% for periods up to 10 years. Equitable then invested the assets short-term to earn the high interest rates guaranteed on the contracts. But short-term interest rates soon came down. When the Equitable had to reinvest, it couldn't get even close to the interest rates it was paying on the GICs. The firm was crippled. Eventually, it had to demutualize and was acquired by the Axa Group. Increasingly banks and asset management companies started to focus on AssetLiability Risk. The problem was not that the value of assets might fall or that the value of liabilities might rise. It was that capital might be depleted by narrowing of the difference between assets and liabilities and that the values of assets and liabilities might fail to move in tandem. Asset-liability risk is predominantly a leveraged form of risk.
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ALM in its most apparent sense is based on funds management. Funds management represents the core of sound bank planning and financial management. Although funding practices, techniques, and norms have been revised substantially in recent years, it is not a new concept. Funds management is the process of managing the spread between interest earned and interest paid while ensuring adequate liquidity. Therefore, funds management has following three components, which have been discussed briefly. A. Liquidity Management Liquidity represents the ability to accommodate decreases in liabilities and to fund increases in assets. An organization has adequate liquidity when it can obtain sufficient funds, either by increasing liabilities or by converting assets, promptly and at a reasonable cost. Liquidity is essential in all organizations to compensate for expected and unexpected balance sheet fluctuations and to provide funds for growth. The price of liquidity is a function of market conditions and market perception of the risks, both interest rate and credit risks, reflected in the balance sheet and off-balance sheet activities in the case of a bank. If liquidity needs are not met through liquid asset holdings, a bank may be forced to restructure or acquire additional liabilities under adverse market conditions. Liquidity exposure can stem from both internally (institution-specific) and externally generated factors. Sound liquidity risk management should address both types of exposure. External liquidity risks can be geographic, systemic or instrument-specific. Internal liquidity risk relates largely to the perception of an institution in its various markets: local, regional, national or international. Determination of the adequacy of a bank's liquidity position depends upon an analysis of its: 14 | P a g e

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Historical funding requirements Current liquidity position Anticipated future funding needs Sources of funds Present and anticipated asset quality Present and future earnings capacity Present and planned capital position As all banks are affected by changes in the economic climate, the monitoring of economic and money market trends is key to liquidity planning. Sound financial management can minimize the negative effects of these trends while accentuating the positive ones. Management must also have an effective contingency plan that identifies minimum and maximum liquidity needs and weighs alternative courses of action designed to meet those needs. The cost of maintaining liquidity is another important prerogative. An institution that maintains a strong liquidity position may do so at the opportunity cost of generating higher earnings. The amount of liquid assets a bank should hold depends on the stability of its deposit structure and the potential for rapid expansion of its loan portfolio. If deposit accounts are composed primarily of small stable accounts, a relatively low allowance for liquidity is necessary. Additionally, management must consider the current ratings by regulatory and rating agencies when planning liquidity needs. Once liquidity needs have been determined, management must decide how to meet them through asset management, liability management, or a combination of both.

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B. Asset Management Many banks (primarily the smaller ones) tend to have little influence over the size of their total assets. Liquid assets enable a bank to provide funds to satisfy increased demand for loans. But banks, which rely solely on asset management, concentrate on adjusting the price and availability of credit and the level of liquid assets. However, assets that are often assumed to be liquid are sometimes difficult to liquidate. For example, investment securities may be pledged against public deposits or repurchase agreements, or may be heavily depreciated because of interest rate changes. Furthermore, the holding of liquid assets for liquidity purposes is less attractive because of thin profit spreads. Asset liquidity, or how "salable" the bank's assets are in terms of both time and cost, is of primary importance in asset management. To maximize profitability, management must carefully weigh the full return on liquid assets (yield plus liquidity value) against the higher return associated with less liquid assets. Income derived from higher yielding assets may be offset if a forced sale, at less than book value, is necessary because of adverse balance sheet fluctuations. Seasonal, cyclical, or other factors may cause aggregate outstanding loans and deposits to move in opposite directions and result in loan demand, which exceeds available deposit funds. A bank relying strictly on asset management would restrict loan growth to that which could be supported by available deposits. The decision whether or not to use liability sources should be based on a complete analysis of seasonal, cyclical, and other factors, and the costs involved. In addition to supplementing asset liquidity, liability sources of liquidity may serve as an alternative even when asset sources are available.

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C. Liability Management Liquidity needs can be met through the discretionary acquisition of funds on the basis of interest rate competition. This does not preclude the option of selling assets to meet funding needs, and conceptually, the availability of asset and liability options should result in a lower liquidity maintenance cost. The alternative costs of available discretionary liabilities can be compared to the opportunity cost of selling various assets. The major difference between liquidity in larger banks and in smaller banks is that larger banks are better able to control the level and composition of their liabilities and assets. When funds are required, larger banks have a wider variety of options from which to select the least costly method of generating funds. The ability to obtain additional liabilities represents liquidity potential. The marginal cost of liquidity and the cost of incremental funds acquired are of paramount importance in evaluating liability sources of liquidity. Consideration must be given to such factors as the frequency with which the banks must regularly refinance maturing purchased liabilities, as well as an evaluation of the bank's ongoing ability to obtain funds under normal market conditions

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RISK MANAGEMENT IN BANKS Risk management in banks











Risks are inherent in banking business. Risk may be simply defined as the probability of loss or damage. Given the complexities of bank balance sheets and rapidity of changes, chances of loss or risks are not only complex in nature but also varied in dimension. Interplay of simultaneous risks makes the ALM both interesting and dangerous and requires the exercise to move beyond a work out for
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insulating profitability risk. Broadly speaking banks are exposed to the following five types of financial risks.

(A) CREDIT RISK The risk of the counter failure in performing the repayment obligation on due date is known as credit risk. Traditionally credit risk management is the primary challenge for financial institution and such risk are regulated by laid down credit/loan policy of the institution. Misjudgment of credit risk may lead to eventual fall of banks. The problems of many of the Japanese banks, failure of savings and loan association in USA in the 80s are cases in example. Even though the credit risk is managed by credit policy, there is a strong inter-relationship between market risk and credit risk. To the extent credit risk is caused by market risk variables, management of such risks becomes part of ALM. In a highly volatile interest rate environment, loan defaults may increase thereby deteriorating the credit quality. (B) INTEREST RATE RISK By traditional definition interest rate risk means changes in the interest income due to changes in the rate of interest. While this focus is not misplaced, it is definitely incomplete in as much as it overlooks an important aspects changes in the interest rate resulting in the value of Assets/Liabilities. Thus interest rate risk may be viewed from two different but complementary perspectives earning sensitivity to rate fluctuations and price sensitivity of instruments/products to changes in interest rate. Absence of appropriate management of interest rates, among other factors, is one of the reasons which had

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accentuated the spell of liquidity problems experienced in the recent past. Changes in the interest rates can affect banks with regards to changes in:

Market value of Assets/liabilities and off balance sheet items, ultimately impacting the value of net worth. Net interest income due to mismatching in the repricing terms of the assets and liabilities. Net income as a result in changes in income. Net interest margin due to changes in interest income. Net income margin owing to changes in interest income and sensitivity of non interest income to rate changes. Net margin for the changes mentioned above (b) to (e) Capital asset ratio due to changes in net margin.

Fluctuations in interest rates, being a very common phenomenon, thus lead to a host of risks of different dimensions to which assets and liabilities of banks are perennially exposed. These risks are as under: RATE LEVEL RISK: Refers to the possibility of rates going up or down during a given period. The general changes in interest rates is a key factor in deciding the mix of asset/liabilities in terms of maturity, type etc. VOLATILITY RISK: Frequency in the changes in interest rate will affect the business volume, product mix and pricing of both assets and liabilities. In a dynamic environment such volatility in rates will have substantial impact on the cash flow and net present value.
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PREPAYMENT RISK: Risks of prepayment of assets resulting in fall of margin. BASIS RISK: Where two rates do not move simultaneously thereby impacting the cash flow in a given time frame. REAL INTEREST RATE RISK: In a inflationary economy the challenge is to manage the real interest cost adjusted to inflation levels. EVENT RISK: Basically refers to risk associated with unforeseen events and is organization specific in nature. (C) LIQUIDITY RISK: Liquidity risk is the potential inability to generate cash to cope with the decline in deposits or increase in assets. Liquidity risk originates from the mismatches in the maturity patterns of asset and liability. There are obvious relationship between liquidity risk and interest rate risk. Banks protect their liquidity position generally by controlling mismatch between maturities of asset and liabilities, focusing on core deposits- the most permanent source of liquidity, and other liquid assets. Since banks deal with assets and liabilities with varied maturity pattern and risk profile, what they need is to strike a reasonable trade-off between being overly liquid and relatively illiquid. One of the basic indicators of liquidity measurement is the ratio of volatile liability to loans. (D) CAPITAL RISK: Maintaining adequate capital on a continuous basis is the sine qua non for sound banking practices. Each bank has to assess how much capital they would require to fulfill the regulatory norms. More than that, in a business situation banks require capital to insulate themselves from the risks of business they undertake and, hence, risks relating to credit, liquidity, interest rates and movement of market prices. Since it is imperative for every bank to understand the
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importance of capital adequacy as also the economic level of capital, management of capital risk is also one of the important plank of the overall balance-sheet management. (E) MARKET RISK: Market risk is the risk to a banks financial condition that would result from adverse movement in market prices. Primarily the impact of market risks is observed in the movement of portfolio value. There is a strong interrelationship between interest rate risk and market risks variables. Inadvertently taken market risk could prove to be dangerous for banks. The fall of Barings and the trouble faced by Daiwa are the cases in point.

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The Reserve bank of India issued draft guidelines in September, 1998 for putting in place a comprehensive Asset Liability Management (ALM) system in banks. The draft guidelines were reviewed by the Reserve Bank in the light of the issued raised/ suggestions made by the banks. The final guidelines revised on the basis of the feed received, were implemented effective April 1, 1999. The banks have been advised to set up an internal Asset Liability Committee headed by the Chief Executive officer/ Chairman and Managing Director or Executive Director. The Management Committee or any specific committee of Board is required to oversee the implementation of the Asset Liability Management system and review its functioning periodically.

TECHNIQUES FOR ASSESSING ALM RISK Techniques for assessing asset-liability risk came to include Gap Analysis and Duration Analysis. These facilitated techniques of managing gaps and matching duration of assets and liabilities. Both approaches worked well if assets and liabilities comprised fixed cash flows. But cases of callable debts, home loans and mortgages which included options of prepayment and floating rates, posed problems that gap analysis could not address. Duration analysis could address these in theory, but implementing sufficiently sophisticated duration measures was problematic. Accordingly, banks and insurance companies started using Scenario Analysis. Under this technique assumptions were made on various conditions, for example: -

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Several interest rate scenarios were specified for the next 5 or 10 years. These specified conditions like declining rates, rising rates, a gradual decrease in rates followed by a sudden rise, etc. Ten or twenty scenarios could be specified in all. Assumptions were made about the performance of assets and liabilities under each scenario. They included prepayment rates on mortgages or surrender rates on insurance products. Assumptions were also made about the firm's performance-the rates at which new business would be acquired for various products, demand for the product etc. Market conditions and economic factors like inflation rates and industrial cycles were also included. Based upon these assumptions, the performance of the firm's balance sheet could be projected under each scenario. If projected performance was poor under specific scenarios, the ALM committee would adjust assets or liabilities to address the indicated exposure. Let us consider the procedure for sanctioning a commercial loan. The borrower, who approaches the bank, has to appraise the banks credit department on various parameters like industry prospects, operational efficiency, financial efficiency, management qualities and other things, which would influence the working of the company. On the basis of this appraisal, the banks would then prepare a credit-grading sheet after covering all the aspects of the company and the business in which the company is in. Then the borrower would then be charged a certain rate of interest, which would cover the risk of lending. But the main shortcoming of scenario analysis was that, it was highly dependent on the choice of scenarios. It also required that many assumptions were to be made about how specific assets or liabilities will perform under specific scenarios. Gradually the firms recognized a potential for different type of risks, which was
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overlooked in ALM analyses. Also the deregulation of the interest rates in US in mid 70 s compelled the banks to undertake active planning for the structure of the balance sheet. The uncertainty of interest rate movements gave rise to Interest Rate Risk thereby causing banks to look for processes to manage this risk. In the wake of interest rate risk came Liquidity Risk and Credit Risk, which became inherent components of risk for banks. The recognition of these risks brought Asset Liability Management to the centre-stage of financial intermediation. Today even Equity Risk, which until a few years ago was given only honorary mention in all but a few company ALM reports, is now an indispensable part of ALM for most companies. Some companies have gone even further to include Counterparty Credit Risk, Sovereign Risk, as well as Product Design and Pricing Risk as part of their overall ALM. Now a day's a company have different reasons for doing ALM. While some companies view ALM as compliance and risk mitigation exercise, others have started using ALM as strategic framework to achieve the company's financial objectives. Some of the business reasons companies now state for implementing an effective ALM framework include gaining competitive advantage and increasing the value of the organization.

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Even though a considerable degree of interest rate deregulation has taken place and the proverbial interest rate volatility hitherto unfamiliar to the Indian banks are slowly being visible, quantification of risk relating to interest rate has not received the kind of attention it deserves. Failure to mange interest rate risk optimally may wreak havoc on banks in as much as they can lose more through interest rate movement than through bad credit decisions. Especially it is more crucial to banks in India in view of the large proportion of their assets are in the form of fixed interest government securities. Hence, management of interest rate risk is s important and so the quantification of risk without which risk management its impracticable. Universally, there are four principal approaches used to quantify the risk .These are under: GAP METHOD: The Gap Approach addresses to the rate sensitivity of assets and liabilities. The gap is the differences between the existing Rate Sensitivity Assets (RSA) and Rate Sensitive Liabilities (RSL) in a particular time period. It ignores the time, in the chosen period, the assets and liabilities would need to be reprised and, hence, shorter the period more sensitive is the model. Interest rate risk is minimized if the gap is managed to near zero for each period. SIMULATION: Simulation involves a series of what if analyses of the impact of interest rate changes on the net income. It therefore requires forecasting the asset liability picture under different scenarios, ascribing probabilities to them and choosing the most optimum model. The method being more dynamics, its utility depends upon the accuracy of forecasts.
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DURATION METHOD: Duration method evaluates the impact of interest rate changes on the market value of assets and liabilities. The duration of an asset or liability is calculated as the weighted average maturity of the resultant cash flows, the weights being the present value of the cash flow. Duration, expressed in the time periods, is less than the maturity for coupon bonds and is equal to maturity for a zero coupon bond. Greater the value of duration gap, higher is the interest rate risk exposure of the assets/liabilities. The method, being too complex, is however, far more flexible. How much interest rate risk a bank should assume, however, depends upon how risk savvy or risk averse the bank is. VALUE AT RISK METHOD: The method enables to work out

depreciation/appreciation in the value of assets/liabilities due to change in interest rate so as to indicate the trend in economic value of portfolio. Impact of interest rate changes on the value of off market items of balance sheets such as loan, deposits etc. need to be calculated under different rate scenarios for evaluating the opportunity cost/benefits of carrying such assets/liabilities in a longer time frame. Although this is a new approach for quantification of risks, this is emerging as a very useful tool for calculating the net worth of the organization at a particular time so as to focus on the longer term risk implications of the decisions that have already been taken/or to be taken.

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In simplistic terms, banks are in a business of buying (borrowing) and selling (lending) money. Interest is the rent earned or paid for the use of money for the term of the related loans, investment or deposits. The margin of interest earned and interest paid is the primary source of earning for most banks. Moving from the conceptual framework, we now break down the earnings so that mangers will be in a position to see how with a given asset base the income earned is determined and then takes remedial measures: THREE-STAGE APPROACH FOR ASSET/LIABILITY MANAGEMENT Step 1 General Asset management Liability management Capital management Loan position management Long-term debt management Liquidity management

Step 2 Specific Investment management Loan management Fixed asset management

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Step 3 Income and Expenditure Revenues management Interest cost Overhead cost Taxes It would be obvious to anyone that higher the percentage of earning assets in the total assets, other things being equal, the higher would be the level of interest income. We have seen from the table above that buildings/equipment/cash earn little interest but need to be supported. As regards composition of earning assets, higher interest flows from loan/cash credit advances than from investment. From the above analysis, it is clear that achieving higher interest through managing interest is the crux of the problem. Higher level of interest rate risk and cost of funds over a period of time. Coming to the cost of funds, the higher the ratio of interest- is bearing funds to average assets, the higher would be the level of expenses and the lower would be the level of net income. Obviously, banks that have substantial current accounts or heavily capitalized would have above average level of income. In a break-up of interest-bearing funds, current and savings accounts are generally the lowest cost funds. Obviously, any bank with an easy access to these funds will have lower cost and higher earnings. Those banks that are forced to have high cost deposits will obviously have higher costs and less income. All these days bankers in India never showed any particular concern about asset/liability mismatches or about GAP management. A bank asset/liability GAP is the difference in reprising between its earning assets and its costing liabilities. Interest rate fluctuations impact both the level of interest income and interest
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expenses. They also effect the level of net interest income. Maximizing net interest income overtime requires co-ordination of funding and investment decision. A banks policies regarding the setting of rates and maturities on loans and deposits may be influenced by overriding marketing considerations, which in turn may be independent of conscious spread management decision. Customer preferences, local competition, national economic condition, etc, may limit a banks option in managing its spread. Trade-offs in terms of interest rate yield versus maturity yield versus credit quality, and pricing versus balance sheet growth may limit flexibility. Maintaining or improving the net interest margin requires management to focus continuously on identifying, quantifying and controlling the interest rate risk related to the structure of its earning asset and interest bearing liability bases. Good spread management does not happen by chancemanagements must work on these problems all the time to build and maintain quality earnings stream. It may be useful to look at the characteristics of successful banks published by the American Bankers Association and the Bank Administration Institute: High performance banks have higher returns on their assets. Interest payments, personnel cost and occupancy expenses were all lower for high performance banks. Loan losses were generally less than one-half of other banks. The extraordinary profitability was due to better ROA rather than higher equity multiplier (EM)

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There has been much debate about who should set capital standards for banks-the banks themselves or the regulatory agencies. It has been argued that banks themselves are best judges of their capital requirement in the long run, The counter agreement is that while a bank may make efficient use of all the information it may have some of the more pertinent information needed to asses a banks true level of risk exposure may be deliberately hidden and it becomes the regulators job to bring this out for proper assessment of its capital requirement to cover possible losses. The incidence of bank failures at international level in the early 1980s seems to have clinched the argument in favor of regulatory agencies determining the minimum capital requirement of all banks, irrespective of their own internal or market situation. These minimum requirements were initially mandated in the U.S.A by congressional passage of the International Lending and Supervision Act of 1983. In 1987, the Federal Reserve Board, representing United States and representatives from eleven other leading industrialized countries announced preliminary agreement on new capital standard often referred to as the Basle Agreement that would be uniformly applied to all banks in their respective jurisdictions. Formally approved in July 1988, those new requirements are designed to encourage banks to strengthen their capital position, reduce inequality in the regulatory rules of different nations and consider the risk to the banks on their off-balance commitments they have made in recent years. The new capital requirements were phased in gradually overtime and became fully enforceable in January 1993, through adjustments and modification continue to be made.
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Sources of Capital Under the terms of Basle Agreement the sources of banks capital are divided into two tiers a Tier I capital (core capital) includes paid up capital, statutory reserve and other disclosed free reserve , Tier II capital (supplementary capital) comprises of undisclosed reserve and cumulative preference shares, revaluation reserves, general provision and loss reserve, hybrid and subordinate debts etc. Indian Standards set by Narasimham Committee In the Indian context, the committee on Banking Sector Reforms (Narasimham Committee II) observed that the capital ratios of Indian banks were generally low and some banks were seriously undercapitalized. The committee pointed out that adequacy of capital has been traditionally regarded as a sign of banking strength irrespective of whether the institution is owned by government or otherwise. It recommended that banks in India should also conform to the standards laid down by the Basle committee. Accordingly Reserve Bank of India has laid down that all commercial banks should attain the minimum CRAR of 8 %, which has to be increased from 8% to 10% in a phased manner with an intermediate target of 9 % by March 2000.

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The central element for the entire ALM exercise is the availability of adequate and accurate information with expedience and the existing systems in many Indian banks do not generate information in the manner required for ALM. Collecting accurate data in a timely manner will be the biggest challenge before the banks, particularly those having wide network of branches but lacking full scale computerization. However, the introduction of base information system for risk measurement and monitoring has to be addressed urgently. 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 sample branches accounting for significant business and then making rational assumptions about the way in which assets and liabilities would behave in other branches The ALCO Committee should meet weekly instead of monthly.

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The rapid changes in banking and financial services market are creating opportunities and challenges. Increased competition in the financial services industry and increased synergies provided by banks result into important benefit to customers. But the increased size, breath, complexity and geographic scope of banking have increased the challenges of managing and of regulating and supervising banks. The central banks worlds wide are also reviewing their positions with regard to electronic, commerce, internal banking and electronic money applications. While freedom is essential to foster efficiency, it also raises an equally important question of appropriate regulatory framework, given the wide divergence between private and social interest in ensuring stability of the financial system. As banks internal risk management and management technologies improve and as depth and sophistication of financial markets increases, bank supervisors should continually find ways to incorporate market advances into their prudential policies, when appropriate. Bank should have their obligation to their shareholders, creditors and customer to measure and manage risk appropriately.

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BOOKS: Banking Law and Practice in India


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