CHAPTER 1

INTRODUCTION

1.1 Asset Liability Management in simple terms

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. This can also be seen in insurance.
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, market risk, and liquidity risk are all interrelated. The Jarrow-Turnbull
model is an example of a risk management methodology that integrates default and
1

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
sensitivity gap and duration calculations.

1.2 Asset Liability Management approach in Indian banks

Asset liability management is a part of overall risk management system in banks. It
implies examinations of all assets and liabilities simultaneously on a continuous
basis with a view to ensuring a proper balance between fund mobilization and their
deployment with respect to their maturity profiles, cost, yields and exposure. It
includes product pricing for deposits as well as advances and the desired maturity
profile of assets and liabilities. ALM is basically a hedging response to the risk in
financial intermediation. It attempts to provide a degree of protection of institution
from intermediation risks and make such risk acceptable. It also provides a
necessary framework to define measure, monitor, modify and manage this risk. In
other words, it is a form of insurance. Thus, the function of ALM is not just
protection from risk. The safety achieved through ALM also opens up
opportunities for enhancing the net worth. It can make it possible for a bank to take
on position that would have been considered too large in the absence of protection
offered by it.
Indian banks remained unconcerned about the ALM till the nineties
because till then they continued to operate in a protected environment.
Nationalization brought a structural change in the Indian banking sector. Wholesale
banking paved the way for retail banking and there has been an all round growth in
branch network, deposit mobilization and credit disbursement. The Narasimhan
2

Committee Report on banking reforms highlighted the weaknesses in the Indian

banking system and suggested measures based on BASEL Committee
recommendations. The guidelines that were issued laid down the foundations for
reformation of the Indian Banking sector. The deregulation of interest rates and the
scope for diversified product profile gave the banks greater leeway in their
operations. New products and operating styles exposed them to newer and greater
risks. At this point, the Reserve Bank of India itself took the responsibility of
initiating risk management practices in banks.
The RBI issued ALM guidelines and to complement them on
October 21, 1999, it issued guidelines on risk management. It was expected that
these two guidelines would help banks to establish an integrated risk management
system. The RBI guidelines on risk management have placed on the board of
directors the primary responsibility of laying down risk parameters and
establishing the risk management and control system. They require that the top
management should give priority to credit risk. The banks should put in place the
loan policy approved by the board of directors and covering the methodologies for
measurement, monitoring and control of credit risk. The banks are expected to
evolve a comprehensive risk rating system that serves as a single point indicator of
the diverse risk factors of counter parties in relation to credit and investment
decisions. Taking into consideration, the diversity and varying size of the balance
sheet items between banks, the RBI also indicated that it would be difficult to
follow a uniform risk management system for all banks. Hence, it was suggested
that the banks could design their risk management framework as per their
respective requirements indicated by the size and complexity of business, risk
philosophy, market perception and the existing level of capital. Thus, banks can
evolve their own systems compatible when the type and size of operations as well
3

as risk perception.
RBI has announced the prudential norms relating to income
recognition, accessed classification and provisioning and the capital adequacy
norms for the banks. These guidelines were intended to ensure that Indian Banks
have been following international standards in risk management. The prudential
norms and capital adequacy norms are to ensure the safety and soundness of the
banks. These norms tackle the risks at macro level. The provisions serve as a
custodian to the banks and ensure that they sustain in the long run. However, banks
face risks in their day to day transactions, which alter their assets and liabilities on
a continuous basis. The change in the profile of the sources and uses of funds is
reflected in the borrowers profile, the industry profile, the exposure limits for the
same interest rate structure for deposits and advances. This has not only led to the
introduction of discriminating only pricing policies but also highlights the need to
match the maturities of the assets and liabilities.
A few banks have set in place advance ALM systems. The RBI
guidelines are aimed at serving as a bench mark for the banks which lack a formal
ALM system. ALM, besides providing information to the supervisory authorities
for quantitative assessments of the interest rate risk faced by banks, help in
strategic and business planning and in accessing risk in advance. The rationale
behind assessing risk on a continuing basis is also to ensure that each banks has
enough capital at all times to cover the risks it occurs. Till now banks have only
focused on maintaining a prudent capital to risk-weighted ratio but lending risk is
not the only risk. Banks have to ensure that are they manage all risks, including
interest rate risk and liquidity risk.
RBI has made it clear to the banks that a mismatch in assets and
4

liabilities in the short-term horizon would be perceived as a warning signal. This is

primarily because if push comes to shove and the bank focus a liquidity squeeze, it
may have to shell out and exorbitant prize to keep its books balanced. This is a
typical problem faced by banks when the Cash Reserve Ratio is hiked. Banks fund
their long term assets through call money market borrowings and when liquidity
becomes tight as a result of the CRR imposition, they have to pay extremely high
rates of interest. In order to manage liquidity, the banks may have to resort to new
instruments like take out finance, refinance and securitization.
The RBI has asked banks to disclose the maturity patterns of their
assets and liabilities basically for two purposes. The first one is to know whether
the banks are keeping in view the maturity pattern of assets and liabilities side.
There is always a as cope for banks to enter into a kind of regular and long term
permanent mismatch. These happens when banks lend for a long term by giving
term and project finance, but then the deposits over one year are not commensurate
with the long term advances portfolio. On the liabilities side, bank's deposits with
maturity over one year are not growing much. At present, bank depositors are not
very sensitive to the maturity aspect because 75% of deposits are owned by
government owned banks which are perceived to be safe. But with the advent of
new private banks and the proposed reduction in holdings of the central
government in the nationalized banks, the depositors will commence watching the
maturity patterns of assets and liabilities and also the extent of mismatch and they
may decide to withdraw funds, if any persistent large-scale mismatch is noticed.
Deposits may migrate to other banks where these maturity gaps are less
pronounced.
The manpower skills, the IT infrastructure and the MIS at the banks
would have to be upgraded substantially. The supervisors would require
5

developing skills in the validation and back testing of models. With the focus on
regulation and risk management the BASEL 2 framework gaining Prominence, the
post-BASEL 2 era will belong to the banks which manage their risk effectively.
The banks with proper risk management systems would not only gain competitive
advantage by way of lower regulatory capital charge but also add value to the
shareholders and other stake holders by properly pricing their services, adequate
provisions and maintaining a robust financial health.

CHAPTER 2
2.1 Concept of Asset Liability Management
Asset liability management is an integrated strategic managerial approach of
managing total balance sheet dynamics having regard to its size and quality in such
a way that the net earnings from interest are minimized with the overall risk
preferences of the bank. It is concerned with management of net interest margin to
ensure that its level and riskiness are compatible with the risk- return objectives of
the bank. This is done by matching of liabilities and assets in terms of maturity,
cost and yield rates. The maturity mismatch and disproportionate changes in the
level of assets and liabilities can cause both liquidity and interest rate risk. ALM is
more than just managing asset-liability items of the banks Balance Sheet.
However, it is an integrated approach to financial management requiring
simultaneous decisions about types of amounts of financial assets and liabilities so
as to insulate the spread from moving in opposite direction. ALM is closely
integrated with the banks business strategy as it has bearing upon the interest risk
profile of the bank. The focus of ALM is not on building up of deposits and loans
in isolation but on net interest income and recognizing interest rate and liquidity
risk. Thus, ALM is essentially guide for survival of a bank in a deregulated
environment

2.2 Asset liability Management and commercial banks in India

Emergence of new players, new instrument and new product at competitive rates in
the market following the reform process in India further increase the bank risk.
This development faced the commercial banks to take a re-look on the asset and
liabilities management to remain competitive and withstand the risk associated
with management of asset and liabilities. The RBI vide its circular dated
FEBRUARY 12 1998, advised commercial banks to tighten their asset liabilities
management and put in place an appropriate system of asset liability management.
The RBI has decided to test a model on the few lending banks whereby banks have
been asked to furnish the data outlined by it.

The RBI guidelines add that:

20-25% of the demand deposit, including saving, should be
considered as withdraw able on the demand and shown under the 1-14
day time bucket
Bank should study the behavioural pattern of the deposit on the basis
of historical trend and base on this bank should classify the deposits
into volatile and core portions
NPA, net of provisions should be shown under the 2-5 years bucket
and sub-standard asset in 1-2 years bucket
Excess balance or the required CRR ad SLR should be shown less
than 1-14 bucket
Bank should study the behavioural and seasonal pattern of drawl in
credit, based on outstanding the core and volatile portion should be
identified, while the volatile portion should be identified
For borrowing on the float rate the amount should be distributed to the
appropriate bucket which, refers to the reprising date while for the
zero coupons, it should be distributed to the maturity bucket relating
to matter of April and October, since the re-price is done only when
RBI changes the rates
The reserve bank of India, has stated the due to the diversity and
varying size of balance sheet item between banks it may neither be possible
nor it may be necessary to adopt the uniform risks management system.
Therefore the design of risk management framework should be oriented
toward the banks own requirement dictated by the size and complexity of
business , risk philosophy, market perception and existing level of capital
thus bank can evolve their own system compatible with the size and
operation as well as risk perception. The banks may critically evaluate their
9

existing risk management in the light of the guidance issue by the RBI and
put in place the proper system for covering the existing deficiencies and
requisites up gradation. The RBI has advised banks to identify GAPS in the
existing risk management practice and the policies and strategies for
complying with the guidelines. The RBI had advised bank in February 1999
to put in place ALM system, effective April 1 1999, and set up internal asset
liability management committee at the top management level to oversee its
implementation. Banks were expected to cover at least 60% of their
liabilities and assets interim and 100% of their business by APRIL 1 2000.
The RBI has also released ALM system guideline in JANUARY 2000 for all
INDIA terms lending and refinancing institutions.

2.3 Asset Liability Management System in banks RBI Guidelines

10

Over the last few years the Indian 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.
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
11

involved. The objective of good risk management programs should be that these
programs will evolve into a strategic tool for bank management.
The 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.

CHAPTER 3
3.1 Components of Asset Liability Management
Assets and Liabilities of banks
Balance Sheet
Liabilities
Capital

Assets
Cash & Bank Balances
12

Reserves & Surplus

Deposits
Borrowings
Other Liabilities & Provisions
Contingent Liabilities

Investments
Advances
Fixed Assets
Other Assets

Liabilities
1. Capital: Capital represents owners contribution/stake in the bank. It serves
as a cushion for depositors and creditors. It is considered to be a long term
sources for the bank.
2. Reserves & Surplus: It includes Statutory Reserves, Capital Reserves,
Investment Fluctuation Reserve, Revenue and Other Reserves, Balance in
Profit and Loss Account
3. Deposits: This is the main source of banks funds. The deposits are
classified as deposits payable on demand and time. This includes
Demand Deposits, Savings Bank Deposits and Term Deposits
4. Borrowings:
Borrowings include Refinance / Borrowings from RBI, Inter-bank & other
institutions
a. Borrowings in India i.e. Reserve Bank of India, Other Banks and
Other Institutions & Agencies
b. Borrowings outside India
5. Other Liabilities & Provisions: It can be grouped as Bills Payable, Interest
Accrued, Unsecured redeemable bonds, and other provisions
Assets
1. Cash & Bank Balances: This includes cash in hand including foreign notes,
balances with Reserve Bank of India in current and other accounts

13

2. Investments: This includes investments in India i.e. Government Securities,

Other approved Securities, Shares, Debentures and Bonds, Subsidiaries and
Sponsored Institutions, Others and investments abroad.
3. Advances: Bills purchased and Discounted, Cash Credits, Overdrafts &
Loans repayable on demand, Term Loans, Secured by tangible assets,
covered by Bank/ Government Guarantees.
4. Fixed Assets: This includes premises, land, furniture & fixtures, etc.
5. Other Assets: This includes Interest accrued, Tax paid in advance/tax
deducted at source, Stationery and Stamps, Non-banking assets acquired in
satisfaction of claims, Deferred Tax Asset (Net) and others.

Asset Repayment Inflows into Banks

Cash
1 - 14 Days Bucket
Excess balance over required CRR
Bank Balance

SLR shown under 1 - 14 Days

Investments
Advances
other Assets

Bucket
Respective Maturity Buckets
Respective Maturity Buckets
Respective Maturity Buckets

Asset Repayment Outflows from the Banks

Capital
Over 5 Years Bucket
Reserves & Surplus
Over 5 Years Bucket
Deposits
Respective
Maturity
14

Borrowings
Other

Liabilities

Buckets
Respective

Maturity

Buckets
and Respective

Maturity

Buckets
Respective

Maturity

Provisions
Contingent Liabilities

Buckets

Contingent Liabilities
Banks obligations under Letter of Credits, Guarantees, and Acceptances on behalf
of constituents and Bills accepted by the bank are reflected under this heads
Profit and Loss Account
Profit and Loss Account includes:
Income
1. Interest Earned: This includes Interest/Discount on Advances / Bills, Income
on Investments, Interest on balances with Reserve Bank of India and other
inter-bank funds
2. Other Income: This includes Commission, Exchange and Brokerage, Profit on
sale of Investments, Profit/ (Loss) on Revaluation of Investments, Profit on sale
of land, buildings and other assets, Profit on exchange transactions,
Miscellaneous Income.
Expenses
1. Interest Expense: This includes Interest on Deposits, Interest on Reserve Bank
of India / Inter-Bank borrowings and others.
15

2. Operating Expense: This includes Payments to and Provisions for employees,

Rent, Taxes and Lighting, Printing and Stationery, Advertisement and Publicity,
etc.

3.2 Objectives of Asset Liability Management

The basic objective of Asset Liability Management is to manage market risk in
such a way as to minimize the impact of net interest income fluctuations in the
short run and protect the net economic value of the bank in the long run.
Thus, the objectives of ALM are as follows:
1.
2.
3.
4.

To control liquidity risk

To control the volatility of net interest income and net economic value of a bank
To control volatility in all target accounts
To ensure an acceptable balance between profitability and growth rate

3.3 Utility of Asset Liability Management

The asset liability management program plans crucial role in ensuring
adequate liquidity in the bank by assessing liquidity needs of the bank managing
simultaneously assets and liabilities of the bank. Thus the utility of asset liability
management for bank lies in the effectiveness to enable the management to achieve
the banks basic objective of maximizing income while controlling its risk exposure
and maintaining reasonable amount of liquidity in an environment of
competitiveness and discontinuity. ALM allows a bank to plan for risk well ahead
of the time that they can prove damaging to its price loan and deposits in a
16

competitive manner and to structure its product in such a way as to attain optimum
level of income with acceptable risk. It also facilitates its earning by imparting
stability to its interest margins.
3.4 Elements of Asset Liability Management
There are nine elements related to ALM and they are as follows:
1. Strategic framework: The Board of Directors are responsible for setting the
limits for risk at global as well as domestic levels. They have to decide how
much risk they are willing to take in quantifiable terms. Also it is necessary to
determine who is in charge of controlling risk in the organization and their
responsibilities.
2. Organizational framework: All elements of the organization like the ALM
Committee, subcommittees, etc., should have clearly defined roles and
responsibilities. ALM activities should be supported by the top management
with proper resource allocation and personnel committee.
3. Operational framework: There should be a proper direction for risk
management with detailed guidelines on all aspects of ALM. The policy
statement should be well articulated providing a clear direction for ALM
function.
4. Analytical framework: Analytical methods in ALM require consistency, which
includes periodic review of the models used to measure risk to avoid
miscalculation and verifying their accuracy. Various analytical components like
Gap, Duration, Stimulation and Value-at-Risk should be used to obtain
appropriate insights.
5. Technology framework: An integrated technological framework is required to
ensure all potential risks are captured and measured on a timely basis. It would
be worthwhile to ensure that automatic information feeds into the ALM systems

17

and he latest software is utilized to enable management perform extensive

analysis, planning and measurement of all facets of the ALM function.
6. Information reporting framework: The information reporting framework
decides who receives information, how timely, how often and in how much
detail and whether the amount and type of information received is appropriate
and necessary for the recipients task.
7. Performance reporting framework: The performance of the traders and
business units can easily be measured using valid risk measurement measures.
The performance measurement considers approaches and ways to adjust
performance measurement for the risks taken. The profitability of an institution
comes from three sources: Asset, Liabilities and their efficient management.
8. Regulatory compliance framework: The objective of regulatory compliance
element is to ensure that there is compliance with the requirements,
expectations and guidelines for risk based capital and liquidity ratios.
9. Control framework: The control framework covers the control over all
processes and systems. The emphasis should be on setting up a system of
checks and balances to ensure the integrity of data, analysis and reporting. This
can be ensured through regular internal / external reviews of the function.

18

CHAPTER 4
4.1 Functions of Asset Liability Management
The basic function of ALM is to guide the management in establishing optimal
match between the assets and liabilities of the bank in such a way as to maximize
its net income and minimize the market risk. This is to be done by analyzing the
current market risk profile of the bank and its impact on the future risk profile. The
Manager has to choose the best course of action depending on the risk preferences
of the management.
(1) Asset Management: The management includes the following.
(a) Cash management: Cash management is a dynamic function that needs to
be dealt with effectively at various levels. Cash balances are the idle assets
of the bank; hence cash should be kept at a bare minimum level. The banks
need to manage their cash balances in order to meet their customer
requirements of their demand deposits.
(b)Reserve and Investment Management: Reserve requirements constitute
the first charge on any banks funds and the balance can be used for
advances and other income generating assets. The reduction in statutory
liquidity ratio helps the banks to invest more resources in profitable avenues.
The banks should plan their requirements properly.
(c) Credit Management: A major portion of banks income is derived from
returns on advances and credit expansion. Managing credit is a critical
function of any bank. Effective credit management is necessary to ensure
that the advances remain performing and the income is maximized.
(d)Management of other Assets: The banks have to invest in other assets in
order to generate more income and not to keep idle assets. It can invest in
19

real estate, government securities, money market etc. However, the creation
of other assets should generate additional income of the bank.
(2) Liability Management: The liability management includes the following.
(a) Owned fund: The banks owned funds are capital and reserve and surplus.
Capital is raised by offering equity to the public. It can also be achieved
through increasing reserves. Capital adequacy has to be maintained by the
banks. It is considered as a financial barometer for the stability and
soundness of a bank.
(b)Deposits: A major source of asset creation of a bank is mobilization of
deposits. It has become a challenging task for banks in these days. Banks
collect funds through different types of deposits having different maturities.
There are some demand deposits also. The banks have to see that these
deposits are repaid on time.
(c) Borrowings: Whenever there is a shortage of funds, banks can borrow from
RBI, financial institutions, and markets. It is also a major source of raising
funds. However, the banks have to consider the rate of interest, maturity and
other statutory requirements, while borrowing from outside.
Floating Funds: The banks have floating funds with them in the form of
bills payables, draft payables. These funds are available for short and
temporary period. These funds have no costs. However, proper
(d)management of these funds requires network of branches, speed in delivery
of service and technological advancement.

Asset- Liability Mismatch Possibilities in a Bank

20

Asset liability management

Classification of Asset-Liability
Long-term asset-Liability

Mismatch
in
amount

Mismatch in
Interest rates

Medium-term asset-Liability

Mismatch
In

Mismatch
Interest rates

amount

Short-term asset-Liability

Mismatch
In amount

Mismatch
Interest
rates

4.2 Process of Asset Liability Management

Asset- liability management is a strategic approach to measure, monitor and
manage the market risk of a bank. The process of ALM involves the following
stages:

(1)Measurement of Risk:
The first step in ALM is to decide or measure the risk. The appropriateness
of risk measurement parameters depends upon the degree of volatility in the
operating environment, availability of supporting data and expertise within
the bank and the expected market and business developments. Generally, the
net interest income and market value of portfolio equity are the two major
parameters which banks employ to measure their balance sheet risk The
short term as well as long-term balance sheet risks can be measured with the
help of these parameters. There are various methods used to measure interest
21

rate risk, the important methods are Gap method, Duration method,
Simulation and Value of Risk Method.
Gap analysis is the important technique used to analyze interest rate risk.
It measures the difference between a banks assets and liabilities and off
balance sheet positions which will be reprised or will mature within a predetermined period. This technique measures the difference between the
absolute value of rate sensitive assets and rate sensitive liabilities over a gap
period. It ignores the time when the assets and liabilities would need to be
reprised. The rate sensitivity gap can be mathematically expressed as
follows:
RSA
RSG :
RSL
Where RSG = Rate Sensitive Gap
RSL
= Rate Sensitive Assets
RSL
= Rate Sensitive Liabilities
A ratio of 1 indicates perfect match of rate sensitive assets to liabilities. If
spread is positive at the beginning of the period, this perfect a match protects
the same even in the wake of subsequent change in interest rates. If the ratio is
greater than one, higher income is produced with increase in interest rates.
Similarly, a ratio of less than 1 produces higher losses with fall in interest rates.
However, a major drawback of Gap analysis is that it ignores the timing of repricing. In actual practice, reprising of assets and liabilities rarely takes place at
the same time.
Duration method attempts to assess the effect of interest rate changes on the
market value of assets and liabilities of the bank. The duration of the assets or
liability is computed as the weighted average maturity of the resultant cash
flows, the weights being the present value of the cash flows. Duration is less
22

than the maturity for coupon bond. Greater the duration gap, higher is the
interest rate risk exposure of the assets or liability.
Simulation method attempts to analyze the impact of change in the interest
rate on the net income under different interest rates and market income market
price scenario. It requires forecasting the asset liability picture under different
scenarios, ascribing probabilities to them and choosing the most optimal model.
This method is more dynamic but it utility depends upon the accuracy of
forecasts. The value of risk method is an attempt to workout depreciation or
appreciation in the value of assets or liabilities due to change in interest rate
with a view to indicate the trend in economic value of portfolio. For evaluation
the opportunity cost benefits carrying off market items of balance sheet such as
loan, deposit etc, in a longer time frame, impact of interest rate changes on the
value of such assets or liabilities under different interest rate scenarios will have
to be calculated. It is also useful to compute the net worth of the bank at a
particular time which will be helpful in ascertaining long-term risk implication
of the decisions which have already been taken or are to be taken.
(2) Enhancement of Long-term Profitability:
The next stage of ALM is identification of favorably priced assets or liabilities and off
balance sheet items so as to enhance long-term profitability for a given level of risk.
The branch managers should resist the temptation of accession to easily found high
price liabilities. Every effort should be made to find out low priced liabilities. The
management has to build up core business and create assets and liabilities for the
bank. The thrust of the management should be on client market and not on a financial
market. Mismatches asset usually built in client market as assets and liabilities are
created sequentially but not simultaneously and the same are managed in financial
markets.
23

(3)Management of Risk:
The third stage in the ALM is effective management of market risk. The directors
should formulate overall investment policy, liquidity policy and the policy
regarding financing. It should also determine the acceptable level of risk in terms
of the parameters chosen. The bank should undertake strategic planning exercise
for its asset-liability. It involves management of CRR and SLR for the Bank as
whole formulating schemes having refinance facilities to have better leverage in
managing the asset-liability and as a spin off earning better profit. The
management should also focus on products and services that are made available to
branches which products and services that are made available to branches which
have special advantage.
The bank should set up an asset-liability management committee giving it the
responsibility of deciding on business and risk management strategy. The
committee should consist of banks senior management with chief executive officer
(CEO) as its head for drawing up strategic plan. The committee should periodically
review the plans in term of market terms, interest rate movement, deposits growth
and financing need of bank. The ALM committee has to address crucial issues like
product pricing of deposits and loans, the derived maturity profile of incremental
assets and liabilities, the extent of exposure in long-dated government securities
and impact of long business deal on banks risk profile. The ALM committee
should review the results and progress in implementations of the decisions. It
should also articulate the current interest rate review of bank and base its decisions
for future business strategy in this regard. The bank can also constitute subcommittees to handle certain important activities and for its better planning and
implementation.
4.3 Risk Managed in ALM
24

When we use the term Risk, we all mean financial risk or uncertainty of financial
loss. If we consider risk in terms of probability of occurrence frequently, we
measure risk on a scale, with certainty of occurrence at one end and certainty of
non-occurrence at the other end.
Risk is the greatest where the probability of occurrence or nonoccurrence is equal. As per the Reserve Bank of India guidelines issued in Oct.
1999, there are three major types of risks encountered by the banks and these are
Credit Risk, Market Risk & Operational Risk. Asset Liability Management
essentially consists of managing the above referred to risks in an effective and
efficient manner.
The ALM function normally derives its charter from the Asset Liability
Committee (ALCO) framework, which sets out the scope of the ALM function, the
risk types that come under its purview and the acceptable levels of risk appetite.
Though the primary focus of ALM is managing balance sheet risks, the ALM
function increasingly tends to focus on balancing profitability while managing
risks, and in the process pro-actively seeks to guard the bottom line and even
maximize profitability.

The different types of risk encompassed in ALM and Liquidity Risk

Management.

25

A). Market Risk

Market Risk may be defined as the possibility of loss to bank caused by the
changes in the market variables. It is the risk that the value of on-/off-balance sheet
positions will be adversely affected by movements in equity and interest rate
markets, currency exchange rates and commodity prices. Market risk is the risk to
the banks earnings and capital due to changes in the market level of interest rates
or prices of securities, foreign exchange and equities, as well as the volatilities, of
those prices. Market Risk Management provides a comprehensive and dynamic
frame work for measuring, monitoring and managing liquidity, interest rate,
foreign exchange and equity as well as commodity price risk of a bank that needs
to be closely integrated with the banks business strategy.
Scenario analysis and stress testing is yet another tool used to assess areas of
potential problems in a given portfolio. Identification of future changes in
economic conditions like economic/industry overturns, market risk events,
liquidity conditions etc that could have unfavorable effect on banks portfolio is a
condition precedent for carrying out stress testing. As the underlying assumption
keep changing from time to time, output of the test should be reviewed periodically
as market risk management system should be responsive and sensitive to the
happenings in the market.
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1. Interest Rate Risk

Financial institutions borrow and lend for different terms and maturity tenors.
Apart from equity and retained earnings, the average maturity of borrowings and
liabilities tend to be on the short to medium term buckets. On the asset side, the
maturity tends to be across a broad range from overnight to as long as a home
mortgage could run. A financial institution is normally required to participate in
lending short, medium and long-terms depending on the nature of financial
products on offer and what segment of the market the bank operates within.

Types of Interest Rate Risk

Re-pricing Risk: The assets and liabilities could re-price at different dates
and might be of a different tenor. For example, a loan on the asset side could
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re-price at three-monthly intervals whereas the deposit could be at a fixed

interest rate or a variable rate, but re-pricing half-yearly. Even if the loan and
deposit re-price similarly, the re-pricing dates do not synchronize.
Basis Risk: The assets could be based on LIBOR rates whereas the
liabilities could be based on Treasury rates or a Swap market rate.
Yield Curve Risk: The yield curve has the potential to change at different
points for differing terms. In other words, the changes are not always
parallel but it could be a twist around a particular tenor and thereby affect
different tenors differently.
Option Risk: The borrowers sometimes (or many times) have the ability to
prepay their borrowings based on contractual terms and conditions. Loan
contracts might have caps, floors, teaser rates, prepayment options and so
on. Exercise of options impacts the financial institutions by giving rise to
premature release of funds that have to be deployed in unfavourable market
conditions and loss of profit on account of foreclosure of loans that earned a
good spread.
2. Credit Risk
Credit Risk is the potential that a bank borrower/counter party fails to meet the
obligations on agreed terms. There is always scope for the borrower to default from
his commitments for one or the other reason resulting in crystallization of credit
risk to the bank. These losses could take the form outright default or alternatively,
losses from changes in portfolio value arising from actual or perceived
deterioration in credit quality that is short of default. Credit risk is inherent to the
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business of lending funds to the operations linked closely to market risk variables.
The objective of credit risk management is to minimize the risk and maximize
banks risk adjusted rate of return by assuming and maintaining credit exposure
within the acceptable parameters.
Credit risk consists of primarily two components, viz Quantity of risk, which is
nothing but the outstanding loan balance as on the date of default and the quality of
risk, viz, the severity of loss defined by both Probability of default as reduced by
the recoveries that could be made in the event of default. Thus credit risk is a
combined outcome of Default Risk and Exposure Risk. The element of Credit Risk
is Portfolio risk comprising Concentration Risk as well as Intrinsic Risk and
Transaction Risk comprising migration/down gradation risk as well as Default
Risk. At the transaction level, credit ratings are useful measures of evaluating
credit risk that is prevalent across the entire organization where treasury and credit
functions are handled. Portfolio analysis help in identifying concentration of credit
risk, default/migration statistics, recovery data, etc.
In general, Default is not an abrupt process to happen suddenly and past experience
dictates that, more often than not, borrowers credit worthiness and asset quality
declines gradually, which is otherwise known as migration. Default is an extreme
event of credit migration. Off balance sheet exposures such as foreign exchange
forward can tracks, swaps options etc are classified in to three broad categories
such as full Risk, Medium Risk and Low risk and then translated into risk Neighed
assets through a conversion factor and summed up. The management of credit risk
includes
a) measurement through credit rating/ scoring, b) Quantification through estimate
of expected loan losses, c) Pricing on a scientific basis and d) Controlling through
effective Loan Review Mechanism and Portfolio Management.
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A. Tools of Credit Risk Management.

The instruments and tools, through which credit risk management is carried out,
are detailed below:
a. Exposure Ceilings: Prudential Limit is linked to Capital Funds say 15%
for individual borrower entity, 40% for a group with additional 10% for
infrastructure projects undertaken by the group, Threshold limit is fixed at a
level lower than Prudential Exposure; Substantial Exposure, which is the
sum total of the exposures beyond threshold limit should not exceed 600%
to 800% of the Capital Funds of the bank (i.e. six to eight times).
b. Review/Renewal: Multi-tier Credit Approving Authority, constitution wise
delegation of powers, Higher delegated powers for better-rated customers;
discriminatory time schedule for review/renewal, Hurdle rates and Bench
marks for fresh exposures and periodicity for renewal based on risk rating,
etc are formulated.
c. Risk Rating Model: Set up comprehensive risk scoring system on a six to
nine point scale. Clearly define rating thresholds and review the ratings
periodically preferably at half yearly intervals. Rating migration is to be
mapped to estimate the expected loss.
d. Risk based scientific pricing: Link loan pricing to expected loss. High-risk
category borrowers are to be priced high. Build historical data on default
losses. Allocate capital to absorb the unexpected loss. Adopt the RAROC
framework.
e. Portfolio Management: The need for credit portfolio management
emanates from the necessity to optimize the benefits associated with
diversification and to reduce the potential adverse impact of concentration of
exposures to a particular borrower, sector or industry. Stipulate quantitative
ceiling on aggregate exposure on specific rating categories, distribution of
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borrowers in various industry, business group and conduct rapid portfolio

reviews. The existing framework of tracking the non-performing loans
around the balance sheet date does not signal the quality of the entire loan
book. There should be a proper & regular on-going system for identification
of credit weaknesses well in advance. Initiate steps to preserve the desired
portfolio quality and integrate portfolio reviews with credit decision-making
process.
f. Loan Review Mechanism: This should be done independent of credit
operations. It is also referred as Credit Audit covering review of sanction
process, compliance status, review of risk rating, and pick up of warning
signals and recommendation of corrective action with the objective of
improving credit quality. It should target all loans above certain cut-off limit
ensuring that at least 30% to 40% of the portfolio is subjected to LRM in a
year so as to ensure that all major credit risks embedded in the balance sheet
have been tracked. This is done to bring about qualitative improvement in
credit administration. Identify loans with credit weakness. Determine
adequacy of loan loss provisions. Ensure adherence to lending policies and
procedures. The focus of the credit audit needs to be broadened from
account level to overall portfolio level. Regular, proper & prompt reporting
to Top Management should be ensured.

B. Risk Rating Model

Credit Audit is conducted on site, i.e. at the branch that has appraised the advance
and where the main operative limits are made available. However, it is not required
to risk borrowers factory/office premises. As observed by RBI, Credit Risk is the
major component of risk management system and this should receive special
attention of the Top Management of the bank. The process of credit risk
31

management needs analysis of uncertainty and analysis of the risks inherent in a

credit proposal.
3. Liquidity Risk
Bank Deposits generally have a much shorter contractual maturity than loans and
liquidity management needs to provide a cushion to cover anticipated deposit
withdrawals. Liquidity is the ability to efficiently accommodate deposit as also
reduction in liabilities and to fund the loan growth and possible funding of the offbalance sheet claims. The cash flows are placed in different time buckets based on
future likely behavior of assets, liabilities and off-balance sheet items. Liquidity
risk consists of Funding Risk, Time Risk & Call Risk.
a. Funding Risk: It is the need to replace net out flows due to unanticipated
withdrawal/nonrenewal of deposit
b. Time risk: It is the need to compensate for non receipt of expected inflows
of funds, i.e. performing assets turning into nonperforming assets.
c. Call risk: It happens on account of crystallization of contingent liabilities
and inability to undertake profitable business opportunities when desired.
The Asset Liability Management (ALM) is a part of the overall risk
management system in the banks. It implies examination of all the
assets and liabilities simultaneously on a continuous basis with a view
to ensuring a proper balance between funds mobilization and their
deployment with respect to their a) maturity profiles, b) cost, c) yield,
d) risk exposure, etc. It includes product pricing for deposits as well as
advances, and the desired maturity profile of assets and liabilities.

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CHAPTER 5
Case study
Case study of Asset Liability Management of bank of Ireland
The Client:
Bank of Ireland Group is a diversified Financial
Services Group with market leading positions in
chosen domestic markets and niche status in other
selected markets. Bank of Ireland was established
in 1783 and has its headquarters in Dublin
employing 16,000 staff group wide. It is the
largest Irish bank by total assets and a highly rated
Irish listed financial institution.
The Challenge:
Due to a building lease expiry, the London branch
of Bank of Ireland took the opportunity to
33

consolidate its client facing staff from 3 sites to a

single new site in the City of London. The Bank
was fortunate to acquire space in new build
premises next to the beautiful Bow Bells Church
on Cheapside. The relocation to the new 70,000 sq
ft premises would require the migration of 400
members of staff from three departments: the
Corporate Banking Group; the Global Markets
Trading Team and, the Business Banking UK
Group. The new premises were spread over 4
floors including Dealers Floor, Executive Meeting
Rooms and Reception and General Office Area.
Since the business had to continue functioning as normal, there was also a
tight weekend migration schedule to adhere to, to ensure that no time was lost.
PTS Consulting was engaged by Bank of Ireland to manage the move
implementation and ensure that all employees could be migrated smoothly as
part of the overall Relocation programme. Acting as Bank of Irelands Move
Management Consultancy partner for the Relocation, PTS Consulting role
would involve close communication and liaison with the Move Coordinators
and the coordination of the work streams to form a migration delivery team.
The Solution:
Prior to the move, PTS attended regular Facilities Management user meetings
where the service solutions were discussed and agreed with the Move
Coordinators. This allowed PTS to build up familiarity with the key staff
34

contacts as well as gaining an understanding of the final service offering. PTS

oversaw the change control process by supporting, developing and managing
occupation of the user schedules. PTS was also asked to coordinate the various
work streams involved in the final project delivery to form a single Migration
Team so that information was shared effectively and version control in the user
schedules maintained. The Move Management program ran over three
weekend phases with a break weekend in between each. PTS Consulting
provided floorwalkers on site during every move phase to ensure that the
migration ran smoothly. The first phase involved the Corporate Banking
Group. The second was the Global Markets trading team and was scheduled
over a bank holiday weekend to allow for system testing. The final move was
the Business Banking Group UK, which involved over 70 meters of filing
being changed from one system to another. PTS Consulting also distributed a
post move questionnaire and provided a helpdesk for post move support whose
role was to answer staff queries, distribute registered issues to owners in the
migration team, and provide resolution updates. PTS Consulting also project
managed the removal contractor, allowing the Bank of Ireland project team to
focus fully on the high level project objectives.
The Benefits:
The Bank of Ireland was able to draw on the PTS Consulting relationship and
Move Management expertise to ensure that the migration went smoothly with
no disruption to business as usual. PTS Consulting ability to communicate at
all levels of the business helped ensure that all possessions and filing for every
employee went to the right place in the new premises on line with the move
schedule. Key features of the project include:
35

Move Management of 400 users from 3 sites into a single new site over 3
weekends Close coordination with the Facilities Management team to ensure Move
Management activities were integrated into the overall Relocation program
Provision, management and change control of the user schedules Packing
instructions and FAQs for staff prior to move Availability of specialist PTS Move
Management Consultants to answer staff queries during the move Helpdesk to take
postmove queries
The Verdict:
PTS Consulting supported Bank of Ireland before, during and after the
migration to its new premises, making sure that the people move was fully co
ordinate with the overall Relocation.
Joe McMahon, Program Manager (London Office Strategy) for Bank of
Ireland commented: I was very impressed with PTS Consulting. It was a very
professional organization. PTS has a deep knowledge of highprofile
Relocation projects and this showed. Thanks to PTS Consulting Move
Management assistance, the move to Bow Bells house went incredibly
smoothly. Everything went as planned and was completed on time. The
benefits of having PTS Consulting experts were that they could coordinate all
the migration work streams on our behalf and deal with any user enquiries on
site leaving us to focus on the project at a more strategic level.

About PTS Consulting

36

PTS Consulting Group PLC (PTS) is one of the world's leading IT

consultancies with a reputation for innovation and thought leadership. PTS is
also renowned for its project management expertise. As the global leader in IT
relocation projects, working with some of the world's largest companies, PTS
has earned a worldwide reputation for independence, professionalism and
quality of service. Headquartered in the UK and founded in 1983, PTS has
worked in over 70 different countries, 250 cities and employs more than 330
staff in the Americas, EMEA and AsiaPacific. www.ptsconsulting.com

CONCLUSION
Asset Liability Management was developed in the 1980s to help
financial institutions control a sharp increase in interest rate risk. Subsequently, it
evolved into a set of techniques that enable financial institutions to manage a much
broader set of risks. ALM is likely to play a growing role in financial institutions
going forward.
In the future, the management of interest rate risk will be more
important to the performance of financial institutions. The removal of regulatory
barriers, combined with a trend toward consolidation, has created larger and more
complex institutions in need of more sophisticated risk management tools.
Regulators and rating agencies are focusing increasingly on the risk management
practices of the institutions they monitor. Finally, impressive technological
progress in the capture, transfer, and processing of data has made sophisticated risk
management techniques available to financial institutions.

37

The more bank managers will take advantage of these new

developments to improve the transparency and flexibility of their business. In large
part because they have adopted more systematic ALM, banks in developed markets
offer more diverse and complex products than their emerging-market counterparts.
An extension of that logic suggests that, even within developed markets, ALM
could be an important determinant of bank product strategy.

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