Asset Liability Management in

Banks

Components of a Bank Balance Sheet

Banks profit and loss account

A banks profit & Loss Account has the
following components:
I.Income:

This includes Interest Income and

Other Income.
II.
Expenses: This includes Interest
Expended, Operating Expenses and
Provisions & contingencies.

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

What is 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 due to default by counter-party, interest rate risk
due to frequent changes in interest rates, and liquidity
risk due to non-availability of deposits on ongoing basis.

Asset-liability management models enable institutions

to measure and monitor risk, and provide suitable
strategies for their management.

An effective Asset Liability Management Technique aims

to manage the volume of Assets & liabilities, Asset
Liability mix, Asset Liability maturity, Asset Liability
rate sensitivity, quality and liquidity of assets and
liabilities as a whole so as to attain a predetermined
acceptable risk/reward ratio

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

3 tools used by banks for ALM

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

Categories of Risk

Risk is the chance or probability of loss or

damage

Credit Risk

Market Risk

Operational Risk

Transaction Risk
/default risk
/counterparty risk
Portfolio risk
/Concentration risk
Settlement risk

Commodity risk

Process risk

Interest Rate risk

Infrastructure risk

Forex rate risk

Model risk

Equity price risk

Human risk

Liquidity risk

But under ALM risks that are typically

managed are.

Liquidity Risk

Liquidity risk arises from funding of long term assets by

short term liabilities, thus making the liabilities subject to
refinancing

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

Statement of structural liquidity

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.

An Example of Structural Liquidity

Statement
15-28
1-14Days Days

Capital
Liab-fixed Int
Liab-floating Int
Others
Total outflow
Investments
Loans-fixed Int
Loans - floating

300 200
350 400
50 50
700 650
200 150
50 50
200 150
Loans BPLR Linked
100 150
Others
50 50
Total Inflow
600 550
Gap
-100 -100
Cumulative Gap -100 -200
-14.29 -15.38
Gap % to Total Outflow

30 Days- 3 Mths - 6 Mths - 1Year - 3 3 Years - Over 5

3 Month 6 Mths
1Year
Years
5 Years Years

200 600 600 300 200

350 450 500 450 450
0
550 1050 1100 750 650
250 250 300 100 350
0 100 150 50 100
200 150 150 150 50
200 500 350 500 100
0
0
0
0
0
650 1000 950 800 600
100 -50 -150 50 -50
-100 -150 -300 -250 -300
18.18

-4.76

-13.64

6.67

-7.69

200
200
450
200
1050
900
100
50
100
200
1350
300
0
28.57

Total

200
2600
3400
300
6500
2500
600
1100
2000
300
6500
0
0

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

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 threemonthly intervals whereas the deposit could be at a fixed
interest rate or a variable rate, but re-pricing 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

Various techniques for measuring exposure
of banks to interest rate risks
Maturity Gap Analysis
Duration
Simulation
Value at Risk

Maturity gap method (IRS)

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

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

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

Value at Risk (VaR)

Refers to the maximum expected loss that a bank can

suffer in market value or income:
Over a given time horizon,
Under normal market conditions,
At a given level or certainty

It enables the calculation of market risk of a portfolio

for which no historical data exists. VaR serves as
Information Reporting to stakeholders

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

Thank You!!!