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ASSET LIABILITY

MANAGEMENT IN BANKS &


BASEL GUIDELINES

Submitted to:
Dr. J K Chandel

Submitted by:
Nisha Aneja
Roll No. 49
MBA-5 Year (10th
Sem)

CONTENTS

Introduction & Evolution of ALM


Purpose and Significance
Tools used for ALM
Categories of Risk
Risk Measurement Techniques
Basel I, II and III

ASSET LIABILITY MANAGEMENT

The process by which an institution manages its balance


sheet in order to allow for alternative interest rate and
liquidity scenarios
Banks and other financial institutions provide services
which expose them to various kinds of risks like credit
risk, interest risk, and liquidity risk
Asset-liability management models enable institutions to
measure and monitor risk, and provide suitable strategies
for their management.

DEFINITION

It is a dynamic process of Planning, Organizing &


Controlling of Assets & Liabilities- their volumes,
mixes, maturities, yields and costs in order to
maintain liquidity and NII.

EVOLUTION

In the 1940s and the 1950s, there was an abundance of funds in banks
in the form of demand and savings deposits. Hence, the focus then
was mainly on asset management

But as the availability of low cost funds started to decline, liability


management became the focus of bank management efforts

In the 1980s, volatility of interest rates in USA and Europe caused the
focus to broaden to include the issue of interest rate risk. ALM began
to extend beyond the bank treasury to cover the loan and deposit
functions

Banks started to concentrate more on the management of both sides


of the balance sheet

PURPOSE & OBJECTIVE OF ALM

An effective Asset Liability Management Technique aims to


manage the volume, mix, maturity, rate sensitivity, quality
and liquidity of assets and liabilities as a whole so as to
attain a predetermined acceptable risk/reward relation.

It is aimed to stabilize short-term profits, long-term earnings and


long-term substance of the bank. The parameters for stabilizing
ALM system are:
1. Net Interest Income (NII)
2. Net Interest Margin (NIM)
3. Economic Equity Ratio

SIGNIFICANCE OF ALM

Volatility

Product Innovations & Complexities

Regulatory Environment

Management Recognition

COMPONENTS OF A BANK BALANCE SHEET


Liabilities

Assets

1.
2.
3.
4.
5.

1. Cash & Balances with RBI


2. Bal. With Banks & Money at
Call and Short Notices
3. Investments
4. Advances
5. Fixed Assets
6. Other Assets

Capital
Reserve & Surplus
Deposits
Borrowings
Other Liabilities

3 TOOLS USED BY BANKS FOR ALM

ALM information systems

ALM Organization

ALM Process

ALM INFORMATION SYSTEMS

Usage of Real Time information system to gather the information


about the maturity and behavior of loans and advances made by
all other branches of a bank

ABC Approach :
analysing the behaviour of asset and liability products in the
top branches as they account for significant business
then making rational assumptions about the way in which
assets and liabilities would behave in other branches
The data and assumptions can then be refined over time as the
bank management gain experience
The spread of computerisation will also help banks in
accessing data.

ALM ORGANIZATION

The board should have overall responsibilities and should set the limit for liquidity, interest rate,
foreign exchange and equity price risk

The Asset - Liability Committee (ALCO)


ALCO, consisting of the bank's senior management (including CEO) should be responsible for
ensuring adherence to the limits set by the Board

Is responsible for balance sheet planning from risk - return perspective including the strategic
management of interest rate and liquidity risks

The role of ALCO includes product pricing for both deposits and advances, desired maturity
profile of the incremental assets and liabilities,

It will have to develop a view on future direction of interest rate movements and decide on a
funding mix between fixed vs floating rate funds, wholesale vs retail deposits, money market vs
capital market funding, domestic vs foreign currency funding

It should review the results of and progress in implementation of the decisions made in the
previous meetings

ALM PROCESS
Risk Parameters
Risk Identification
Risk Measurement
Risk Management
Risk Policies and
Tolerance Level

CATEGORIES OF RISK

Risk is the chance or probability of loss or damages

Credit Risk

Market Risk

Operational Risk

Transaction Risk /default


risk /counterparty risk

Commodity risk

Process risk

Portfolio risk
/Concentration risk

Interest Rate risk

Infrastructure risk

Settlement risk

Forex rate risk

Model risk

Equity price risk

Human risk

Liquidity risk

BUT UNDER ALM RISKS THAT ARE TYPICALLY


MANAGED ARE.

Liquidity Risk
Currency Risk
Interest Rate Risk

LIQUIDITY RISK
Liquidity risk arises from funding of long term assets
by short term liabilities, thus making the liabilities
subject
Funding
risk

to refinancing.

Arises due to unanticipated withdrawals


of the deposits from wholesale or retail
clients

Time risk

It arises when an asset turns into a NPA. So,


the expected cash flows are no longer
available to the bank.

Call Risk

Due to crystallisation of contingent


liabilities and unable to undertake
profitable business opportunities when
available.

LIQUIDITY RISK MANAGEMENT

Banks liquidity management is the process of generating funds to


meet contractual or relationship obligations at reasonable prices at all
times.

Liquidity Management is the ability of bank to ensure that its


liabilities are met as they become due. Liquidity positions of bank
should be measured on an ongoing basis.

A standard tool for measuring and managing net funding


requirements, is the use of maturity ladder and calculation of
cumulative surplus or deficit of funds as selected maturity dates is
adopted

STATEMENT OF STRUCTURAL LIQUIDITY

All Assets & Liabilities to be reported as per their maturity profile


into 8 maturity Buckets:

i.

1 to 14 days

ii.

15 to 28 days

iii.

29 days and up to 3 months

iv.

Over 3 months and up to 6 months

v.

Over 6 months and up to 1 year

vi.

Over 1 year and up to 3 years

vii.

Over 3 years and up to 5 years

viii.

Over 5 years

Places all cash inflows and outflows in the maturity ladder as per
residual maturity

Maturing Liability: cash outflow

Maturing Assets : Cash Inflow

Classified in to 8 time buckets

Mismatches in the first two buckets not to exceed 20% of outflows

Shows the structure as of a particular date

Banks can fix higher tolerance level for other maturity buckets.

ADDRESSING THE MISMATCHES

Mismatches can be positive or negative


Positive Mismatch: M.A.>M.L. and Negative Mismatch
M.L.>M.A.

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.

CURRENCY RISK

The increased capital flows from different nations


following deregulation have contributed to increase
in the volume of transactions. Dealing in different
currencies brings opportunities as well as risk.

To prevent this banks have been setting up


overnight limits and undertaking active day time
trading.

Value at Risk approach to be used to measure the


risk associated with forward exposures. Value at
Risk estimates probability of portfolio losses based
on the statistical analysis of historical price trends
and volatilities.

INTEREST RATE RISK

Interest Rate risk is the exposure of a banks financial


conditions to adverse movements of interest rates

Though this is normal part of banking business, excessive


interest rate risk can pose a significant threat to a banks
earnings and capital base

Changes in interest rates also affect the underlying value


of the banks assets, liabilities and off-balance-sheet item

Interest rate risk refers to volatility in Net Interest Income


(NII) or variations in Net Interest Margin(NIM)

NIM = (Interest income Interest expense) / Earning


assets

SOURCES OF INTEREST RATE RISK


Basis

Options

Interest
Rate
Risk

Yield

Repricing

Re-pricing Risk: The assets and liabilities could re-price at different


dates and might be of different time period. For example, a loan on
the asset side could re-price at three-monthly intervals whereas the
deposit could be at a fixed interest rate or a variable rate, but repricing half-yearly.

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 changes are not always parallel but it could
be a twist around a particular tenor and thereby affecting different
maturities differently.

Option Risk: 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.

RISK MEASUREMENT TECHNIQUES

Gap Analysis- Simple maturity/re-pricing Schedules can be used


to generate simple indicators of interest rate risk sensitivity of
both earnings and economic value to changing interest rates.

If a negative gap occurs (RSA<RSL) in given time band, an


increase in market interest rates could cause a decline in NII.
- conversely, a positive gap (RSA>RSL) in a given time band, an
decrease in market interest rates could cause a decline in NII.

THREE OPTIONS:
A) Rate Sensitive Assets>Rate Sensitive Liabilities= Positive Gap
B) Rate Sensitive Assets<Rate Sensitive Liabilities = Negative Gap
C) Rate Sensitive Assets=Rate Sensitive Liabilities = Zero Gap

The basic weakness with this model is that this method takes into
account only the book value of assets and liabilities and hence
ignores their market value.
Duration Analysis
It basically refers to the average life of the asset or the liability. It
is the weighted average time to maturity of all the preset values of
cash flows

The larger the value of the duration, the more sensitive is the price
of that asset or liability to changes in interest rates.

As per the above equation, the bank will be immunized from


interest rate risk if the duration gap between assets and the
liabilities is zero.

SIMULATION

Basically simulation models utilize computer power


to provide what if scenarios, for example: What if:

The absolute level of interest rates shift


Marketing plans are under-or-over achieved
Margins achieved in the past are not sustained/improved
Bad debt and prepayment levels change in different
interest rate scenarios
There are changes in the funding mix e.g.: an increasing
reliance on short-term funds for balance sheet growth

This dynamic capability adds value to this method


and improves the quality of information available to
the management

CAPITAL ADEQUACY RATIO

Capital adequacy provides regulators with a means of


establishing whether banks and other financial institutions
have sufficient capital to keep them out of difficulty.
Regulators use a Capital Adequacy Ratio (CAR), a ratio
of a banks capital to its assets, to assess risk.

CAR = (Banks Capital)/(Risk Weighted Assets)


= (Tier I Capital + Tier II Capital)/(Risk
Weighted Assets)

BASEL I NORMS

In 1988, the Basel Committee(BCBS) in Basel,


Switzerland, published a set of minimal capital
requirements for banks, known as 1988 BaselAccord or
Basel 1.
Primary focus on credit risk
Assets of banks were classified and grouped in five
categories to credit risk weights of zero 0, 10, 20, 50
and up to 100%.
Assets like cash and coins usually have zero risk weight,
while unsecured loans might have a risk weight of 100%.

CAPITAL ADEQUACY RATIO (CAR)

Expressed as a percentage of a bank's risk weighted


credit exposures.
Also known as "Capital to Risk Weighted Assets Ratio
(CRAR).

Ratio is used to protect depositors and promote the


stability and efficiency of financial systems around the
world.

Total Capital
( at least 8% of total risk-weighted assets)

Tier 1 Capital

The book value At least 4% of


of its stock + total
riskretained earnings weighted assets

Tier 2 Capital
Loan-loss
reserves
subordinated
debt.

PURPOSE OF BASEL 1
1.

2.

Strengthen the stability of international banking


system.
Set up a fair and a consistent international
banking system in order to decrease competitive
inequality among international banks

Achievement :
To set up a minimum risk-based capital adequacy
applying to all banks and governments in the world

RISK CATEGORIZATION
According to Basel I, the total capital should represent at
least 8% of the banks credit risk.
Risks can be:
The on-balance sheet risk (like risks associated with cash
& gold held with bank, government bonds, corporate
bonds etc.)
Market risk including interest rates, foreign exchange,
equity derivatives & commodities.
Non Trading off-balance sheet risks like forward
purchase of assets or transaction related debt assets

LIMITATIONS OF BASEL I NORMS

Limited differentiation of credit risk

Static measure of default risk

No recognition of term-structure of credit risk

Simplified calculation of potential future counterparty


risk

Lack of recognition of portfolio diversification effects

BASEL II NORMS
Basel II norms are based on 3 pillars:
Minimum Capital Banks must hold capital against 8% of their assets, after
adjusting their assets for risk
Supervisory Review It is the process whereby national regulators ensure their
home country banks are following the rules.
Market Discipline It is based on enhanced disclosure of risk

Risk Categorization

In the Basel II accord, Credit Risk, Market Risk and Operational Risks were
recognized.
Under Basel II, Credit Risk has three approaches namely, standardized,
foundation internal ratings- based (IRB), and advanced IRB.
Operational Risk has measurement approaches like the Basic Indicator approach,
Standardized approach and the Advanced Measurement approach.

Advantages of Basel II over I

The discrepancy between economic capital and regulatory capital is reduced


significantly, due to that the regulatory requirements will rely on banks own risk
methods.

More Risk sensitive

Wider recognition of credit risk mitigation.

Pitfalls of Basel II norms

Too much regulatory compliance

Over Focusing on Credit Risk

The new Accord is complex and therefore demanding for


supervisors, and unsophisticated banks

Strong risk differentiation in the new Accord can adversely affect


the borrowing position of risky borrowers

BASEL III NORMS


Basel III norms aim to:

Improving the banking sector's ability to absorb shocks arising


from financial and economic stress
Improve risk management and governance
Strengthen banks' transparency and disclosures

Structure of Basel III Accord

Minimum Regulatory Capital Requirements based on Risk Weighted Assets


(RWAs) : Maintaining capital calculated through credit, market and operational
risk areas.
Supervisory Review Process : Regulating tools and frameworks for dealing
with peripheral risks that banks face
Market Discipline : Increasing the disclosures that banks must provide to
increase the transparency of banks

MAJOR CHANGES IN BASEL - III

Better Capital Quality


Capital Conservation Buffer
Minimum Common Equity and Tier I Capital requirements
Leverage Ratios
Liquidity Ratios
Systematically Important Financial Institutions

THANK YOU

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