Asset-Liability Management & Risk Management

1. Balance Sheet Analysis

Introduction
It is important for a bank to manage each item in its balance sheet, in order to
function efficiently and profitably. At the same time it is vital that the
management of the different components be coordinated so that they jointly
contribute to the goals of the organization. Coordinated management of the
entire portfolio of a bank or financial institution is referred to as AssetLiability Management. ALM is looked after by a special Asset-Liability
Management Committee (ALCO).
For a bank, small percentage changes in assets or liabilities can translate into
large percentage changes in earnings and profits. Banks address this risk by
means of Asset-Liability Management, which basically means structuring their
assets to hedge their liabilities. For example, if a liability represents a longterm fixed income obligation, a bank might hold long-term bonds or give term
loans as a hedging asset. In this way, changes in the value of the liability are
mirrored by changes in the value of the assets, and the difference between
the two is unaffected.
Asset-liability management (ALM) can be performed on a per-liability basis,
matching a specific asset to support each liability. Alternatively, it can be
performed across the balance sheet. With the latter approach, the net
exposures of the organization's liabilities is determined, and a portfolio of
assets is maintained which hedges those exposures.
While most banks in other economies began with strategic planning for asset
liability management as early as 1970, Indian banks remained unconcerned
about the same. Till the 1980s, Indian banks continued to operate in a
protected environment. In fact, the deregulation that began in international
markets during the 1970s almost coincided with the nationalization of banks in
India during 1969.
Indian banks did meet the objectives of nationalization - there was an allround growth in branch network, deposit mobilization and credit disbursement.
But all this was at the cost of profitability of the banks. Quality became
secondary to quantity and political interference was an additional problem.
The reform measures in the Indian economy in 1991 necessitated the
deregulation of the financial sector, particularly the banking sector. The
Narasimham Committee Report on the banking sector reforms highlighted the
weaknesses in the Indian banking system and suggested reform measures
based on the Basle norms. The guidelines that were issued subsequently laid
the foundation for the reformation of Indian banking sector. The initiation of

the financial sector reforms in 1993 brought about a complete transformation

in the banking industry.
The financial sector reform process has forced banks to strengthen their
balance sheets and also to try and reach international standards. Banking
activities are very complex and subjective judgements are a part of any
reporting technique. Data can therefore often be misleading. Areas in which
this can happen relate to the size of the bank (window dressing), liquidity and
quality of assets (loans and investments), classification of advances (into
standard, sub-standard, doubtful, poor), etc.
Prior to the introduction of financial sector reforms, banks had considerable
freedom with respect to reporting. However, the RBI has now made several
modifications in this area with a view to strengthening banks and also
ensuring conformity with international accounting standards. The RBI has
introduced prudential norms relating to Income Recognition, Asset
Classification and Provisioning as also the Capital Adequacy norms. These
guidelines have ensured that Indian banks follow international standards in
balance sheet preparation and risk management.

What is Asset Liability Management or What is ALM ?

Asset liability management (ALM) can be defined as the comprehensive and
dynamic framework for measuring, monitoring and managing the financial
risks associated with changing interest rates, foreign exchange rates and other
factors that can affect the organisations liquidity.

ALM relates to management of structure of balance sheet (liabilities and

assets) in such a way that the net earning from interest is maximised within
the overall risk-preference (present and future) of the institutions.

Thus the ALM functions includes the tools adopted to mitigating liquidly risk,
management of interest rate risk / market risk and trading risk management.
In short, ALM is the sum of the financial risk management of any financial
institution.

In other words, ALM is all about managing three central risks:

Interest Rate Risk
Liquidity Risk
Foreign currency risk

Brief structure of a banks balance sheet:

Liabilities
Capital
Deposits
Borrowings
Profit

Assets
Cash
Investments
Loans & Advances

Analysing Bank Balance Sheets

Prior to the financial sector reforms, the balance sheets of banks were not
very useful for judging their performance, because there was no transparency
and there was also a lot of window dressing. For instance, assets were not
classified as per international norms, banks were showing accrued rather than
realized interest in their books, etc.
The balance sheet must provide complete information based on consistent
methods of preparation in order to be comparable over time. There are certain
generally accepted principles of accounting and balance sheet presentation
which Indian banks have begun to follow only after the introduction of the
financial sector reforms. These relate to income recognition, asset
classification, provisioning, etc.
It is important to note that compared to commercial and industrial concerns,
banks are highly leveraged. Leverage, measured by the ratio of shareholders
equity to assets, typically ranges from 6 to 10 percent. This implies that 1
rupee of equity supports Rs. 10 Rs. 17 of banking assets. Banks operate by
stretching equity and adding deposits and other liabilities.
There are several techniques used to analyse the balance sheets of banks.
Some of the more common techniques are discussed below.
1.

2.

Peer Group Comparisons: Banking is relatively homogenous and

banks with similar asset size tend to be very similar in respect of their
operations and structure. It would be worthwhile to compare one banks
performance with that of another similar bank. The key questions that would
arise in such an analysis would be:

Why is the performance of this bank at variance with that of the peer
group? This performance could be in respect of costs, business
composition, sectoral distribution, etc.

How far can a given activity be sustained?

Is the bank dependent on some unique or local factors for its market
share or advances focus?

Multi-Layered Analysis: Multi-Layered balance sheets and income

statements analysis gives us an indication of the trends and shifts in volume

between the major items. The income statements bring out the sources of
income and items on which expenditure has been incurred.
3.

Key Ratio Analysis: Ratio analysis is the process of determining and

presenting the relationship of items or group of items in financial statements,
and is a powerful tool of financial analysis. Ratios help to summarize large
data to draw qualitative judgements about the banks performance. Given
below are various points which highlight the significance of ratio analysis
these are relevant for all organizations, including financial institutions.
a.

Simplifies accounting figures Ratios simplify and summarize

accounting figures

b.

Measures liquidity position Liquidity position of a firm is said to

be satisfactory if it is able to meet its current obligations as and when they
mature. Hence liquidity ratios are used by banks and other short term
lenders for looking into the liquidity position of the company.

c.

For comparison They are useful tools in the hands of

management to evaluate the firms performance over a period of time by
comparing the present ratios with the past ratios and comparing with other
companies also so as to see where the company stands in the industry.

d.

Profitability Profit and loss account reveals the profit earned or

loss incurred during a period but fails to convey the capacity of the
company to earn in terms of per dollar invested or per dollar of sales; this
is where ratio analysis comes into play and hence very significant in terms
of measuring the profitability.

e.

Trend analysis Trend analysis of ratios reveals whether

financial position of the company is improving or deteriorating over time
because it enables a company to take the time dimension into account.
With the help of such analysis, one can ascertain whether the trend is
favorable or not.

f.

Long term solvency Ratio analysis also evaluates long term

solvency of the firm through capital structure or leverage ratios. It is used
by creditors, security analysts and present and prospective investors
because these ratios reveal whether or not company is financially sound.

The standard ratios used for bank financial statement analysis are given
below. A bank can compare these ratios with a peer group norm, or its own
past record, or target ratios, to judge its performance. The ratios are grouped
into various performance categories.
i)

Liquidity Ratios
Govt securities / Total Assets

Govt securities such as Treasury Bills are among the most liquid of assets,
mainly on account of the low level of risk associated with them. Further, these
are short-term securities and there is always a market for them on account of
the SLR requirements that banks and financial institutions have to fulfill.
Market value of Securities / Book value of

Securities

The market value of any security represents the amount that can be realized
by sale of the security. A value higher than 1 suggests that the bank has
greater liquidity than that suggested by the banks financial statements. Banks
are now required to mark to market on a regular basis, i.e. they are
supposed to value their investments in their books at market value, in which
case the book value and market value of securities will not differ greatly and
the value of these ratios will be close to 1.
Short-term loans & other cash credit a/c due in

1 year / Total loans

These are loans and advances that are of short-term duration and are the
most liquid of bank loans and advances. The greater the proportion of these
loans in total advances, the greater will be the banks liquidity position.
These 3 ratios measure the liquidity of the assets of a bank how easily can
the assets be liquidated in case of need. The higher the value of these ratios,
the more liquid is the banks asset position.
Similarly there are ratios that measure the liquidity of a banks liabilities
Liability liquidity
Large Deposits / total liabilities

Dependence on a few large deposits exposes a bank to a great amount of

liquidity risk. Thus the higher this ratio, the greater the liquidity risk.
Other liabilities or borrowed funds / total

liabilities

Borrowed funds are usually a sign that a bank does not have adequate
liquidity. Thus a higher ratio is a sign of lower liquidity.
ii)

Earning Asset Ratios

Total Advances / Total Assets

(Total Advances + Govt. Securities) / Total Assets

These ratios measure the level and distribution of earning asset portfolio. The
advances-to-assets ratio indicates the trade-off between earnings and
liquidity. A higher ratio indicates greater earning potential, but lower liquidity.

By studying these ratios one can get considerable insight into the portfolio
strategy of the bank.
iii)

Financial Structure Ratios

Total Assets / Net Worth

Earnings before Interest & Taxes (EBIT) / Total Interest Expense

These ratios focus on 2 aspects of a commercial banks financial structure.

The first ratio addresses questions about the way an institution finances its
assets while the second measures the banks ability to meet its interest
expenses.
iv)

Operating Expense Ratios

Operating Expenses / Operating Income

Establishment Expenses / Operating Expenses

Total Interest Expenses / Operating Expenses

These ratios measure the level and distribution of total operating costs.
The first ratio indicates the expenditure incurred to earn 1 rupee of income. A
higher ratio is clearly undesirable as it indicates that a greater portion of
revenue is absorbed by costs, resulting in lower profitability.
The second ratio reflects upon the ability of management to control costs.
The last ratio shows how much of a banks expenses are accounted for by
interest payments on deposits. A higher ratio here would in a sense be
acceptable, as it would show that most of a banks expenses are on account
of acquisition of funds for the purpose of lending and investment.
v)

Net Interest Margin Ratios

Interest Income / Earning Assets

Interest Expenses / Earning Assets

Net Interest Margin Ratios measure the rate of return on earning assets and
the sensitivity of return to market yields
vi)

Profitability Ratios

Net Income / Operating Income (ROI)

Net Income / Total Assets (ROA)

Net Income / Net Worth (ROE)

Profitability ratios measure a banks effectiveness in generating income. They

are, in fact, the key monitors of financial health because adequate returns are
necessary to sustain the flow of capital.

4.

Liquid Asset Schedule Analysis: this analysis brings out the

managements approach to liquidity management, its liquidity policy and also
reflects on its portfolio strategy. Low levels of liquid assets (compared to that
of peer groups) may indicate excessive risk-taking, as would large unrealized
gains or losses in govt securities. Liquidity ratios measure the risk of not being
able to meet customer needs.

5.

ROE Decomposition Analysis: ROE is the product of ROA and the

equity multiplier. The management of a bank has control over some of the
factors affecting the return on assets, while there are other factors that are
beyond its control. The figure below gives us an idea of these factors.
This method helps to conduct a full Dupont-style analysis of a financial
institution. Dupont analysis decomposes an institutions ROE into its various
components, thus pinpointing the causes of differences in ROE of a bank (i)
from one period to another and (ii) from that of another peer bank.
In a competitive environment, the management of a bank would try to
maiximise return on equity. It has to therefore find ways to improve all the
underlying components. The two most basic choices are to increase the
return on assets or to increase the equity multiplier.

Return on Equity
Return on Assets

Interest Margin/
Average Assets

Equity Multiplier

Non-Interest Margin/

Non-Operating Margin/

Average Assets

Average Assets

Taxes
Average Assets

Interest Margin/
Earning Assets

Spread

6.

Sources & Application of Funds: This analytical tool shows where

the bank acquired its resources and how it used them during a given period of
time. The format to show the application and uses of funds is to cast the
statement in terms of changes in working reserves. The statement starts with
the working reserve position at the beginning of the period and then indicates
the factors that are added to or reduced from the reserves during the period.
Sources

Uses

Net Income
Depreciation & other items
Increase in liabilities
Deposits & other liabilities
Decease in assets
Disposal of securities & funds
Total sources of cash reserves

Increase in assets
Interest bearing deposits
Premises & equipment
Decease in liabilities
Securities sold
Funds purchased
Debentures
Dividends

It is essentially a flow statement and therefore incremental figures have to be

chosen. This statement is particularly useful to monitor the asset/liability
position.
7.

Common Size Financial Statements: such statements express

individual accounts as a percentage of an aggregate total. Income statement
categories are expressed as a percentage of operating revenue and each
item on the balance sheet is expressed as a percentage of total assets. These
percentages could be compared with those of peer groups and management
could look for causes of differences, or it could be used for time series
analysis. Management must remember the absolute amounts and the reasons
for changes in them.

8.

CAMELS Rating: these days it is customary to use CAMEL rating

ratios to assess bank performance the RBI uses these ratios as well. In
1995, RBI had set up a working group under the chairmanship of Shri S.
Padmanabhan to review the banking supervision system. Based on the
recommendations of the Committee, in 1998 the RBI introduced a rating
system for banks based on the international CAMELS model combining
financial management and systems and control elements. The Committee
recommended that banks should be rated on a five point scale on the lines of
international CAMELS rating model. CAMELS evaluates banks on the
following six parameters :(a)

Capital Adequacy: Capital adequacy is measured by the ratio of

capital to risk-weighted assets (CRAR). A sound capital base strengthens
confidence of depositors

(b)

Asset Quality: One of the indicators for asset quality is the ratio
of non-performing loans to total loans (GNPA). The gross non-performing
loans to gross advances ratio is indicative of the quality of credit decisions
made by bankers. Higher GNPA is indicative of poor credit decisionmaking.

(c)

Management: The ratio of non-interest expenditures to total

assets can be one of the measures to assess the working of the
management. This variable, which includes a variety of expenses, such as

payroll, workers compensation and training investment, reflects the

management policy stance.
(d)

Earnings: It can be measured as the return on asset (ROA)

ratio.

(e)

Liquidity: Cash maintained by the banks and balances with

central bank, to total asset ratio is an indicator of bank's liquidity. In
general, banks with a larger volume of liquid assets are perceived safe,
since these assets would allow banks to meet unexpected withdrawals.

(f)

Systems and Control

Each of the above six parameters are weighted on a scale of 1 to 100 and
contains number of sub-parameters with individual weightages.
Rating
Symbol

9.

Interpretation

Bank is sound in every respect

Bank is fundamentally sound but with moderate weaknesses

Financial, operational or compliance weaknesses that give

cause for supervisory concern.

Serious or immoderate finance, operational and managerial

weaknesses that could impair future viability

Critical financial weaknesses and there is high possibility of

failure in the near future.

Trend Analysis: Trend analysis shows the level of growth a bank has
achieved on each component of the banks financial statements. Suppose a
bank shows a growth in income of 40% over a 3-year period, but its costs
have increased by 45% over the same period, its profitability is clearly
adversely affected.

PROCESS OF ALM
Improving Bank Balance Sheets
In the above section we have discussed how to analyze and understand the
strengths and weaknesses of a bank based upon an analysis of its balance
sheet. It is, however, more important to now how to improve the balance
sheet. This is possible through ALM.
Experts have identified a 3-stage approach to improving bank balance sheets
through ALM
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Step 1: General

Asset Management

Liability Management
o Capital Mgmt
o Loan Position Mgmt
o Long-term Debt Mgmt

Step 2: Specific

Liquidity Mgmt

Investment Mgmt

Loan Mgmt

Fixed Asset Mgmt

Step 3: Income & Expenditure Mgmt

Interest Costs

Overhead Costs

Interest earnings

Non-Interest Income

Taxes

The following measures can be seen to belong to any of the 3 steps

mentioned above and are all part of the ALM approach to improving the
balance sheets of banks
1.

The higher the percentage of earning assets in total assets,

the higher would be the level of income and profitability. Buildings, equipment
and cash (all non-earning assets) earn the bank no income but have to be
supported.

2.

As regards composition of earning assets, higher interest

flows from loans and advances than from investments.

3.

It is important to manage interest rates. Higher rates of interest

should not be viewed in isolation but in the light of interest rate risk and cost of
funds over a period of time.

4.

Coming to the cost of funds, the higher the ratio of interestbearing funds to average assets, the higher would be the level of expenses
and the lower would be the level of net income. Banks that are heavily
capitalized or have higher volumes of current accounts would have lower
levels of interest expenditure and higher levels of net income.
10

5.

In a break-up of interest-bearing funds, current and savings

account deposits are generally the lowest cost funds. Banks with greater
access to such deposits would enjoy higher levels of net income and
profitability.

6.

All banks would have an Asset-Liability Gap, i.e. a mismatch or

a difference in repricing between its earning assets and its costing liabilities.
Asset-Liability gap management is essential for ensuring a healthy and safe
balance sheet.

7.

Interest rate fluctuations affect both interest income and interest

expenditure. Maximizing net interest income over time requires coordination
of funding, lending and investment decisions.

8.

Loan losses cannot be avoided but can surely be minimized.

These are only a few of the means by which a bank can improve its balance
sheet. The bank can look at every item in its balance sheet and see how best
it can be manipulated to achieve better profitability. This is the essence of
Asset-Liability Management.

TREASURY OPERATIONS
Treasury management or treasury operations includes management of a
bank's investments, i.e. its holdings in and trading in government and
corporate bonds, currencies, financial futures, options and derivatives,
payment systems and the associated financial risk management.
All banks have departments devoted to treasury management, as do larger
corporations.
There are two reasons why treasury operations and treasury management are
important in banks.
First, in the current highly competitive environment, banks are facing
tremendous competition for loans and advances and consequently a
downward pressure on their profits. Management of investments has
therefore come to occupy a prominent position in banks operations.
Second, a banks liabilities are of short-term nature, while its major assets
loans are long-term. This mismatch can be corrected by appropriate
investments, which is what treasury operations is all about.
It is important for banks to have an investment policy. The major objectives of
any banks investment policy are to ensure that investments are managed
well so that

SLR requirements are complied with

Adequate liquidity is ensured

11

Right amounts of cash resources are available in the right place at the
right time

Returns on surplus funds are maximized

Assets and liabilities are properly matched in terms of maturity &

returns, and

Financial costs are minimized

The Treasury Dept of a bank is concerned with the following functions

a) Risk exposure management which includes credit, currency, liquidity and
interest rate risk considerations, along with the risks associated with
dealing in foreign exchange.
b) Asset & Liability Management where liquidity, interest rate structure and
maturity profiles are the major considerations, in addition to managing dayto-day funding considerations
c) Control and development of dealing functions
d) Funding of investments in subsidiaries and affiliates
e) Raising capital debt/loan stock
f) Control of investments
g) Fraud protection
The basis of treasury management is money and near-money assets such as
money market instruments, govt securities, securities of corporates etc.
Foreign currency is also traded in the forex market as part of treasury
operations. These are the areas where the treasury manager operates.
All trading in financial assets takes place in distinct segments of the financial
markets of a country.
1) The major segment for treasury operations is the call money market for
borrowing and lending of money for periods ranging from a few hours to
up to 14 days.
2) Treasury Bills of the Govt of India and commercial bills of exchange are
traded in the bill market.
3) Participation certificates, commercial paper, certificates of deposit and
factorization bills are all discounted and traded in the money market.
4) Raising and trading in long-term funds takes place in the capital market,
with new issues being traded in the primary market and existing securities
traded in the secondary market. Treasury operations in this market involve
trading in

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Govt funds or securities (other than TBs), semi-govt bonds,

PSU bonds, etc. in the gilt-edged market

Equity shares, preference shares and various types of

debentures (fully convertible debentures, partially convertible
debentures and non- convertible debentures)

Units of mutual funds schemes

5) In the forex market, forex dealings are carried out involving the
conversion of rupees into foreign currencies and vice versa. In addition to
currencies, the other instruments traded in this market include short-term
notes and bills, medium and long-term bonds, forward currencies,
currency derivatives, etc.

For banks with forex operations, it also includes managing

Currency risk

13

Through ALM banks try to match the assets and liabilities in terms of Maturities and
Interest Rates Sensitivities so as to minimize the interest rate risk and liquidity risk.

Overview of what are asset liability mismatches :

The Assets and Liabilities of the banks B/Sheet are nothing but future cash inflows
& outflows. Under Asset Liability Management i.e. ALM, these inflows & outflows
are grouped into different time buckets. Then each bucket of assets is matched with
the corresponding bucket of liability.
The differences in each bucket are known as mismatches.

Is complete matching of Assets & Liabilities in the Balance sheet necessary?

No, because banks can even make money as a result of such mismatches sometimes.
Alam Greenspan, ex-Chairman of US Federal Reserve has once observed risk taking
is necessary condition for wealth creation. However, it is a risky proposition to keep
large mismatches as it can lead to massive losses in a volatile market. Therefore, in
practice, the idea is to limit the mismatches rather than aim at zero mismatches.

Evolution of ALM in Indian Banking System:

In view of the regulated environment in India in 1970s to early 1990s, there was no
interest rate risk as the interest rate were regulated and prescribed by RBI. Spreads
between deposits and lending rates were very wide. At that time banks Balance
Sheets were not being managed by banks themselves as they were being managed
through prescriptions of the regulatory authority and the government. With the
deregulation of interest rates, banks were given a large amount of freedom to
manage their Balance sheets. Thus, it became necessary to introduce ALM
guidelines so that banks can be prevented from big losses on account of wide ALM
mismatches.

Reserve Bank of India issued its first ALM Guidelines in February 1999, which was
made effective from 1 st April 1999. These guidelines covered, inter alia, interest rate
risk and liquidity risk measurement/ reporting framework and prudential limits. Gap
statements were required to be prepared by scheduling all assets and liabilities
according to the stated or anticipated re-pricing date or maturity date. The Assets and
Liabilities at this stage were required to be divided into 8 maturity buckets (1-14 days;
15-28 days; 29-90 days; 91-180 days; 181-365 days, 1-3 years and 3-5 years and
above 5 years), based on the remaining period to their maturity (also called residual
maturity).. All the liability figures were to be considered as outflows while the asset
figures were considered as inflows.
14

As a measure of liquidity management, banks were required to monitor their

cumulative mismatches across all time buckets in their statement of structural
liquidity by establishing internal prudential limits with the approval of their boards/
management committees. As per the guidelines, in the normal course, the mismatches
(negative gap) in the time buckets of 1-14 days and 15-28 days were not to exceed
20 per cent of the cash outflows in the respective time buckets
Later on RBI made it mandatory for banks to form ALCO (Asset Liability
Committee) as a Committee of the Board of Directors to track, monitor and report
ALM.

It was in September, 2007, in response to the international practices and to meet the
need for a sharper assessment of the efficacy of liquidity management and with a view
to providing a stimulus for development of the term-money market, RBI fine tuned
these guidelines and it was provided that the banks may adopt a more granular
approach to measurement of liquidity risk by splitting the first time bucket (1-14 days
at present) in the Statement of Structural Liquidity into three time buckets viz., 1 day
(called next day) , 2-7 days and 8-14 days. Thus, banks were asked to put their
maturing asset and liabilities in 10 time buckets.

Thus as per October 2007 RBI guidelines, banks were advised that the net cumulative
negative mismatches during the next day, 2-7 days, 8-14 days and 15-28 days should
not exceed 5%, 10%, 15% and 20% of the cumulative outflows, respectively, in order
to recognize the cumulative impact on liquidity. Banks were also advised to undertake
dynamic liquidity management and prepare the statement of structural liquidity on a
daily basis. In the absence of a fully networked environment, banks were allowed to
compile the statement on best available data coverage initially but were advised to
make conscious efforts to attain 100 per cent data coverage in a timely manner.
Similarly, the statement of structural liquidity was to be reported to the Reserve
Bank, once a month, as on the third Wednesday of every month. The frequency of
supervisory reporting of the structural liquidity position was increased to fortnightly,
with effect from April 1, 2008. Banks are now required to submit the statement of
structural liquidity as on the first and third Wednesday of every month to the Reserve
Bank.

Boards of the Banks were entrusted with the overall responsibility for the
management of risks and required to decide the risk management policy and set limits
for liquidity, interest rate, foreign exchange and equity price risks.

15

Asset-Liability Committee (ALCO), the top most committee to oversee the

implementation of ALM system is to be headed by CMD /ED. ALCO considers
product pricing for both deposits and advances, the desired maturity profile of the
incremental assets and liabilities in addition to monitoring the risk levels of the bank.
It will have to articulate current interest rates view of the bank and base its decisions
for future business strategy on this view.

Progress in Adoption of Techniques of ALM by Indian Banks : ALM process involve

in identification , measurement and management of risk Parameter. In its original
guidelines RBI asked the banks to use traditional techniques like Gap analysis for
monitoring interest rates and liquidity risk. At that RBI desired that Indian Banks
slowly move towards sophisticated techniques like duration , simulation and Value at
risk in future. Now with the passage of time, more and more banks are moving
towards these advanced techniques.

Asset- Liability Management Techniques :

ALM is bank specific control mechanism, but it is possible that several banks may
employ similar ALM techniques or each bank may use unique system.

Gap Analysis : Gap Analysis is a technique of Asset Liability management . It is

used to assess interest rate risk or liquidity risk. It measures at a given point of time
the gaps between Rate Sensitive Liabilities (RSL) and Rate Sensitive Assets (RSA)
(including off balance sheet position) by grouping them into time buckets according
to residual maturity or next re-pricing period , whichever is earlier. An asset or
liability is treated as rate sensitive if;

i)Within time bucket under consideration is a cash flow.

ii.) The interest rate resets/reprices contractually during time buckets
iii.) Administered rates are changed and
iv.) It is contractually pre-payable or withdrawal allowed before contracted maturities.
Thus ;
GAP=RSA-RSL
GAP Ratio=RSAs/RSL

Mismatches can be positive or negative

16

Positive Mismatch: M.A.>M.L. and vice-versa for Negative Mismatch

In case of +ve mismatch, excess liquidity can be deployed in money market
instruments, creating new assets & investment swaps etc.
For ve mismatch,it can be financed from market
borrowings(call/Term),Bills rediscounting,repos & deployment of foreign
currency converted into rupee.

Gap analysis was widely used by financial institutions during late 1990s and early
years of present century in India. The table below gives you idea who does a positive
or negative gap would impact on NII in case there is upward or downward movement
of interest rates:

Gap

Interest rate Change

Impact on NII

Positive

Increases

Positive

Positive

Decreases

Negative

Negative

Increases

Negative

Negative

Decreases

Positive

Duration Gap Analysis :

This is an alternative method for measuring interest-rate risk. This technique
examines the sensitivity of the market value of the financial institutions net worth to
changes in interest rates. Duration analysis is based on Macaulays concept of
duration, which measures the average lifetime of a securitys stream of payments.
We know that Duration is an important measure of the interest rate sensitivity of
assets and liabilities as it takes into account the time of arrival of cash flows and the
maturity of assets and liabilities. It is the weighted average time to maturity of all the
preset values of cash flows. Duration basically refers to the average life of the asset or
the liability. DP /p =D ( dR /1+R) The above equation describes the percentage fall in
price of the bond for a given increase in the required interest rates or yields.
The larger the value of the duration, the more sensitive is the price of that asset or
liability to changes in interest rates. Thus, as per this theory, the bank will be
immunized from interest rate risk if the duration gap between assets and the liabilities
is zero. The duration model has one important benefit. It uses the market value of
assets and liabilities.

17

Duration analysis summarises with a single number exposure to parallel shifts in the
term structure of interest rates.
It can be noticed that both gap and duration approaches worked well if assets and
liabilities comprised fixed cash flows. However options such as those embedded in
mortgages or callable debt posed problems that gap analysis could not address.
Duration analysis could address these in theory, but implementing sufficiently
sophisticated duration measures was problematic.

Scenario Analysis :
Under the scenario analysis of ALM several interest rate scenarios are created during
next 5 to 10 years . Such scenarios might specify declining interest rates , rising
interests rates, a gradual decrease in rates followed by sudden rise etc. Different
scenarios may specify the behavior of the entire yield curve, so there could be
scenarios with flattening yield curve, inverted yield curves etc. Ten to twenty
scenarios might be specified to have a holistic view of the scnario analysis. Next
assumptions would be made about the performances of assets and liabilities under
each scenario. Assumptions might include prepayment rates on mortgages and
surrender rates on insurance products. Assumptions may also be made about the firms
performance . Based upon these assumptions the performance of the firms balance
sheet could be projected under each scenario. If projected performance was poor
under specific scenario the ALCO might adjust assets or liabilities to address the
indicated exposure . A short coming of scenario analysis is the fact that it is highly
dependent on the choice of scenario. It also requires that many assumptions be made
about how specific assets or liabilities will perform under specific scenario.
Value at Risk
VaR or Value ar Risk refers to the maximum expected loss that a bank can suffer over
a target horizon, given a certain confidence interval. It enables the calculation of
market risk of a portfolio for which no historical data exists. It enables one to
calculate the net worth of the organization at any particular point of time so that it is
possible to focus on long term risk implications of decisions that have already been
taken or that are going to be taken. It is used extensively for measuring the market
risk of a portfolio of assets and/or liabilities.

Conclusion:
We can conclude to say that ALM is an important tool for monitoring, measuring and
managing the interest rate risk, liquidity risk and foreign currency risk of a bank. With
the deregulation of interest regime in India , the banking industry has been exposed to
interest rate risk / market risk . Hence to manage such risk, ALM needs to be used so
that the management is able to assess the risks and cover some of these by taking
appropriate decisions.

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Asset Liability Management of Banks and Financial Institutions

In banking institutions, asset and liability management is the practice of managing
various risks that arise due to mismatches between the assets and liabilities (loans and
advances) of the bank.
Banks face several risks such as the risks associated with assets,interest,currency
exchange risks. Asset Liability management (ALM) is at tool to manage interest rate
risk and liquidity risk faced by various banks, other financial services companies .
Mismatch of assets and liabilities:
Banks manage the risks of ALM mismatch by matching various assets and liabilities
according to the maturity pattern or the matching the duration, by hedging and by
securities.
Increasing integrated risks 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.
What is ALM;
It is an attempt to match: Assets and Liabilities In terms of: Maturities and Interest
Rates Sensitivities To minimize: Interest Rate Risk and Liquidity Risk.
ALM is an integral part of the
financial management process of any bank. It is concerned with strategic balance
sheet management involving risks caused by changes in the interest rates, exchange
rates and the liquidity position of the bank. While managing these three risks forms
the crux of ALM, credit risk and contingency risk also form a part of the ALM
ALM can be termed as a risk management technique designed to earn an adequate
return while maintaining a comfortable surplus of assets beyond liabilities. It takes
into consideration interest rates, earning power, and degree of willingness to take on
debt and hence is also known as Surplus Management

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Definition of ALM:
ALM is defined as, the process of decision making to control risks of existence,
stability and growth of a system through the dynamic balances of its assets and
liabilities.
The text book definition of ALM :
It is a risk management technique designed to earn an adequate return while
maintaining a comfortable surplus of assets beyond liabilities. It takes into
consideration interest rates, earning power and degree of willingness to take on debt.
It is also called surplus- management.
International scenes:
Over the last few years the financial markets worldwide 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.
The ALM process rests on three pillars:
1) ALM information systems
2) Management Information System
3) Information availability, accuracy, adequacy and expediency
ALM involves identification of Risk parameters, Risk identification, Risk
measurement and Risk management and framing of Risk policies and tolerance levels.
ALM information systems;

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Information is the key to the ALM process. Considering the large network of branches
and the lack of an adequate system to collect information required for ALM which
analyses information on the basis of residual maturity and behavioral pattern it will
take time for banks in the present state to get the requisite information.
Measuring and managing liquidity needs are vital activities of commercial banks. By
assuring a banks ability to meet its liabilities as they become due, liquidity
management can reduce the probability of an adverse situation developing.
The importance of liquidity:
It transcends individual institutions, as liquidity shortfall in one institution can have
repercussions on the entire system. Bank management should measure not only the
liquidity positions of banks on an ongoing basis but also examine how liquidity
requirements are likely to evolve under crisis scenarios.
Experience shows that assets commonly considered as liquid like Government
securities and other money market instruments could also become illiquid when the
market and players are Unidirectional. Therefore liquidity has to be tracked through
maturity or cash flow mismatches.
Various types of risks with assets:
Currency Risk;
Floating exchange rate arrangement has brought in its wake pronounced volatility
adding a new dimension to the risk profile of banks balance sheets. The increased
capital flows across free economies following deregulation have contributed to
increase in the volume of transactions.
Large cross border flows together with the volatility has rendered the banks balance
sheets vulnerable to exchange rate movements.
Dealing in different currencies;
It brings opportunities as also risks. If the liabilities in one currency exceed the level
of assets in the same currency, then the currency mismatch can add value or erode
value depending upon the currency movements. The simplest way to avoid currency
risk is to ensure that mismatches, if any, are reduced to zero or near zero.

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Banks undertake operations in foreign exchange like accepting deposits, making loans
and advances and quoting prices for foreign exchange transactions. Irrespective of the
strategies adopted, it may not
be possible to eliminate currency mismatches altogether. Besides, some of the
institutions may take proprietary trading positions as a conscious business strategy.
Managing Currency Risk is one more dimension of Asset- Liability Management.
Mismatched currency position besides exposing the balance sheet to movements in
exchange rate also exposes it to country risk and settlement risk. Ever since the RBI
(Exchange Control Department) introduced the concept of end of the day near square
position in 1978, banks have been setting up overnight limits and selectively
undertaking active day time trading.
Interest Rate Risk (IRR);
The phased deregulation of interest rates and the operational flexibility given to banks
in pricing most of the assets and liabilities have exposed the banking system to
Interest Rate Risk.
Interest rate risk is the risk where changes in market interest rates might adversely
affect a banks financial condition. Changes in interest rates affect both the current
earnings (earnings perspective) as also the net worth of the bank (economic value
perspective). The risk from the earnings perspective can be measured as changes in
the Net Interest Income (Nil) or Net Interest
Margin (NIM).
Problem with poor Management Information systems;
In the context of poor MIS, slow pace of computerisation in banks and the absence of
total deregulation, the traditional Gap analysis is considered as a suitable method to
measure the Interest Rate Risk. It is the intention of RBI to move over to modern
techniques of Interest Rate Risk measurement like Duration Gap Analysis, Simulation
and Value at Risk at a later date when banks acquire sufficient expertise and
sophistication in MIS.
The Gap or mismatch risk can be measured by calculating Gaps over different time
intervals as at a givendate. Gap analysis measures mismatches between rate sensitive
liabilities and rate sensitive assets(including off-balance sheet positions). An asset or
liability is normally classified as rate sensitive
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if: The Gap Report should be generated by grouping rate sensitive liabilities, assets
and off balance sheet positions into time buckets according to residual maturity or
next reprising period, whichever is earlier. The difficult task in Gap analysis is
determining rate sensitivity. All investments, advances, deposits, borrowings,
purchased funds etc. that mature/reprice within a specified timeframe are interest rate
sensitive. Similarly, any principal repayment of loan is also rate sensitive if the bank
expects to receive it within the time horizon. This includes final principal payment
and interim instalments. Certain assets and liabilities receive/pay rates that vary with a
reference rate. These assets and liabilities are repriced at pre-determined intervals and
are rate sensitive at the time of repricing. While the interest rates on term deposits are
fixed during their currency, the advances portfolio of the banking system is basically
floating. The interest rates on advances could be repriced any number of occasions,
corresponding to the changes in PLR.
Risks in ALM :
It is the risk of having a negative impact on a banks future earnings and on the
market value of its equity due to changes in interest rates. Liquidity Risk: It is the risk
of having insufficient liquid assets to meet the liabilities at a given time.
Forex Risk: It is the risk of having losses in foreign exchange assets and liabilities due
to exchanges in exchange rates among multi-currencies under consideration.
Conclusion; thus ALM is a continuous and day to day matter which has to be
carefully managed and preventive steps taken to mitigate the problems associated
with it. It may cause irreparable damage to the banks in terms of liquidity, profitability
and solvency, if not monitored properly.

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