Asset Liability Management

Risks in Banking

Interest rate risk :

Risk that arises when the interest income/ market
value of the bank is sensitive to the interest rate
fluctuations.

Credit Risk :
Risk that arises due to the possibility of a
default/delay in the repayment obligation by the
borrowers of funds.
 Risks in Banking

Liquidity risk :
Risk that arises due to the mismatch in the maturity
patterns of the assets and liabilities.

Treasury management risk :

Risk to the banks due to changes in cash flows in its
deposit and credit structure that requires an obligation to
maintain liquidity.
 Risks in Banking

Operational risk:
Risk arising out of fluctuations in day to day
operations of the banks.

Market risk:
Risk of events reducing the return expectation of
bank capital owners.
 Risks in Banking

Foreign Exchange/Currency Risk:

Risk that arises due to unanticipated fluctuation
in exchange rates.

Contingency risk:
Risk that arises due to the presence of off-
balance sheet items such as guarantees, letters of credit,
underwriting commitments etc.
 Interest Rate Risk Management

• Interest rate risk management deals with the possibility

that future events could change the return expectation of
banks.

• Risk management provides strategies, techniques, tools

and approaches to handle interest rate change
implications for banks.
 Interest Rate Risk Management Tasks

• Evaluate the quantum of loss likely to occur due to

interest rate change.

• Organize the structure of banking operations to react

to interest rate changes.

• Balance the risk control mechanism of a bank to

manage risk and maintain expected returns.

• Managing risks by foreseeing the interest rate

changes and make informed banking decisions to
utilize the opportunities and minimize the threats.
 Interest Rate Risk Management Goal

• Maximize bank profits.

• Creating opportunity out of interest rate risk.

• Minimize risk and protect the bank assets.

• Reduce losses arising out of interest rate commitments

by banks.
 Asset-Liability Management (ALM)

• Asset-liability management considers the effect of bank

profits on the overall bank strategy.

• The nature of capital of banks being small when

compared to its asset structure, any change in asset
structure is likely to prove detrimental to the bank’s
profitability.

• Banks need to examine the effect of changes in capital to

changes in the asset structure simultaneously to enhance
overall profits.
 Sample Bank Balance Sheet

Liabilities Assets

Capital 20000 Reserves 85000

Borrowings 10000 Advances 588000

Short term  550000 Investments 100000

deposits
Long term  200000 Fixed Assets 7000
deposits
Total 780000 Total 780000

What if advances value is reduced by 2%? –

 What if Advances Value is Reduced by 2%? –
Approximately 58.8% Reduction in Capital!!!

Liabilities Assets

Capital 8240 Reserves 85000

Borrowings 10000 Advances 576240

Short term  550000 Investments 100000

deposits
Long term  200000 Fixed Assets 7000
deposits
Total 768240 Total 768240
 Risks Handled by ALM

• Core risk

• Changes in interest rates

• Changes in exchange rates

• Changes in liquidity position of the bank

• Additional risk

• Credit risk

• Contingency risk
 ALM Risk Management Models

• Asset Models

• Liability Models

• Randomness Models

• Multi-dimensional Models

• CALM (Computer Aided Asset/ Liability Management)

Stochastic Programming Model
 Asset Models

• Analyze risk in terms of bank assets

- Advances
- Loan syndication
- Investments
• Analyze returns of bank assets
- Credit default
- Portfolio loss
• Model determination
- Long term / Short term
 Liability Models

• Deposit maturity structure

• Borrowings management

• Bond risk management / Immunization of bond portfolios

• Swap structures for management of interest rate risk

• Management of liability driven investments

 Randomness Models

• Random parameters

- Asset price

- Interest rates

- Credit default

- Deposit flow

- Inflation rate

- Market price
Multi-Dimensional Models
 CALM Stochastic Programming Models

• Dynamic asset liability management

• Computer aided applications by banks

• Optimization decision model based on constraints

• Uncertainty in terms of asset and liability flows

• Change in asset and liability classes

 Multi-Stage Stochastic Programming

First Stage Decision Observation

n’th Observation

Second Stage Decision n’th Stage Decision

 Managing Interest Rate Risk

• Manage the volume

• Manage the mix
• Manage the maturity
• Manage the rate sensitivity
• Manage the quality
• Manage the liquidity of the assets and liabilities
• Achievement of a predetermined acceptable
risk/reward ratio
 Parameters for ALM

Net Interest Margin (NIM) :

Impact of volatility on the short-term profits is measured by
NIM.
To stabilize the short-term profits the banks aim at
minimizing fluctuations in the NIM.

Net Interest Income

Net Interest Margin 
Total Assests
 Parameters for ALM

Market Value of Equity (MVE) :

The market value of equity represents the long-term
profits of the bank. The banks aim at minimizing adverse
movement in their market value due to interest rate
fluctuations.

In the case of unlisted banks, the difference between

the market value of assets and liabilities represent the
target that is to be achieved by the banks.
 Parameters for ALM

Economic Equity Ratio :

This ratio measures the shifts in the ratio of owned
funds to total funds.

Evaluates the sustenance capacity of a bank.

Economic Equity Ratio = Shareholder ' s Funds

Total Assests
 Managing Bank Risk - A Note by Reserve Bank of
India

• Traditional methods
- Operational limits on credit lines
- Loan provisioning
- Portfolio diversification
- Collateralization
 RBI Note on Managing Bank Risk - Innovative methods

• Loan securitization

• Capital adequacy guidelines

• Derivatives

- Swap products

- Option products (spread options, sovereign risk options)

- Forward Rate Agreements

 Prerequisites for Risk Management

• A well-developed Repo market

• Forward trading in securities
• Revolving Underwriting facilities
• Introduction of asset-liability based derivatives (Strips and
Asset Backed Securities)
- Benchmark securities
- Fungibility, auction system, settlement procedures and
market infrastructure
• A strong money market