The Value of Asset Liability Management Example for Free

The Asset-Liability Management is one of the most crucial functions of a bank in the highly competitive and complex business environment today. Asset-Liability Management is a co-ordinated management of a bank's balance sheet to allow for different interest rate, liquidity and optionality shocks. Post Liberalization in 1991, deregulation of various banking operations, freeing of interest rates, entry of new generation banks increasing the competition, diversifying of banking activities, integration of Indian banking into the world, introduction of new, complex products in the market, have all led to increase in the volatility in the financial market. In such a scenario, there are various opportunities, but they all come up certain risks, which if not handled carefully could wipe out a bank's profits and may even result in its bankruptcy. The recent global financial crisis has further reinforced the importance of asset-liability management in banks and the current market scenario in India has meant that banks have been facing asset-liability mismatch in their balance sheets as well.

The 2 major types of market risks a banks faces are Liquidity Risk and Interest Rate risks, which are primarily addressed by the Asset-Liability Management of a bank. The methods and approaches towards Asset-Liability Management have evolved over the years due to changes in the business environment and the governing body for commercial banks in India, RBI, has prescribed certain guidelines from time to time to make sure all commercial banks fall in line and follow a uniform method for the same. In its recent Monetary Policy Review, RBI expressed concern towards the current asset-liability situation in the banks and asked banks to curb their lending, which has gone well In excess of their deposits, leading to straight negative mismatch and liquidity crunch in the system. Also, the constant increases by RBI in the Repo rates (due to inflationary pressure) over the past 1 year has led to increase in cost of funds for the banks, hitting their Net Interest Margins. The banks recently have been forced to increase their deposit rates significantly to attract fresh deposits to address the liquidity problem, which will also lead to decrease in their profit margins in the ongoing and future quarters. The paper will also discuss how the Asset-Liability Management is carried out at State Bank of India, India's largest bank.

WHAT IS ASSET LIABILITY MANAGEMENT (ALM)

ALM is the management of total balance sheet dynamics with regard to the size and quality. It is a process of adjusting bank liability to meet loan demands, liquidity needs and safety requirements. Asset liability management is a philosophy under which the bank can target assets growth by adjusting liabilities to suit their needs. It's focus is on Profitability Long term operating viability It is a co-ordinated management of a bank's balance sheet to allow for different interest rate, liquidity and optionality shocks. It involves: On balance-sheet match of the assets and liabilities being re-priced. Off balance sheet hedging of the on balance-sheet risks. Securitization, to remove the risk from the balance sheet. Alignment of branch level targets with broader goals of bank. Centralization of liquidity and interest rate risks. It is a process to match Assets and liabilities In terms of maturities and interest rate sensitivities to minimize Interest rate risk and liquidity risk. ALM involves Quantification of risks Conscious decision making with regard to asset liability structure in order to maximise interest earnings within the frame work of perceived risks.

There are various benefits of having a proper Asset-Liability Management: Awareness of various risks in the banking book, beyond credit risk. Risk appetite for the banking book and at the portfolio level is clearly defined once hidden risks are known to the bank. Strategies to manage or mitigate intermediation risks. Hedging with capital or derivatives. Enhancement of net worth. Limits based on risk/ return trade-off - much larger low-risk positions can be assumed with the knowledge of ALM. Entry into lucrative high-risk businesses with the guidance of ALM, if (i) they are weakly related to the existing portfolio or (ii) bank has access to options.

ALM was in response to much sharper stock market, exchange rate, price and interest rate volatility since the early 1970s. The following events led to its evolution globally:

Savings and Loans Associations (S&L) in California, USA offered LT, fixed-rate, mortgage-backed housing loans, funded by ST deposits. Money market funds offered higher deposit rates, to reduce S&L deposits on a large-scale, in the 1970s. S&L deposit rates were deregulated. Cost of funding went up much faster than rise in yields on advances. NII simulations showed high book value of capital - decline in reported NII was gradual. Regulatory capital lowered to 3% of assets. Restrictions on S&L lending lifted. Large-Scale book insolvency by mid-1980s.

The result of high exchange rate, price and interest rate volatility. High bailout cost ($154 billion) - result of regulatory laxity and political connections. Exposure to interest risk, even in the non-tradable banking book, with volatile rates. Maturity mismatch between assets and liabilities. Focus on opportunity costs even for non-tradable products, like loans, rather than their book values.

Composition of Orange County Investment Pool (OCIP) in 1994: Long-term securities, with maturities between 3 and 5 years - around 47%. Long-term inverse floaters, with maturities between 3 and 5 years - around 33%. For an inverse floater, the coupon falls as rate rises. They were both funded by short-term deposits and repo ( < 180 days) borrowing. Assumption of steady or declining rates worked till end-1993 - huge NII gains and profits for OCIP. Rise in market rates - Fed Funds and Long-term - by 250 bps in 1994. Sharp fall in value of assets and repo collateral - funding liquidity crunch. On December 1, 2004, Orange County announced a loss of USD 1.6 billion and filed for bankruptcy. The plea that Assets and Liabilities were HTM was rejected and assets liquidated at low market value.

In case of positive mismatch, there is excess liquidity in the bank for the concerned maturity bucket and this excess liquidity can be deployed in money market instruments, interbank lending in call money market, bill discounting, creating new assets, investment swaps etc. In case of a negative mismatch, there is shortage of liquidity in the bank for the concerned maturity bucket and this can be financed from interbank borrowings in call money market, bill rediscounting, Repo borrowings, liquidation of investments, deployment of foreign currency converted into Rupee and so on. This is the statement of Structural Liquidity which a bank must prepare daily and report to RBI atleast once every month, as on the 3rd Wednesday of every month. RBI has prescribed limits for the negative mismatches in the first 4 buckets. The net cumulative negative mismatches during the Next day, 2-7 days, 8-14 days and 15-28 days buckets should not exceed 5 % ,10%, 15 % and 20 % of the cumulative cash outflows in the respective first 4 buckets. However, a bank may keep additional limits at their own discretion in addition to these limits.

INTEREST RATE RISK MANAGEMENT IN BANKS

The deregulation of interest rates and the operational flexibility given to banks to price most of their assets and liabilities has led to the need of Interest Rate Risk Management. Interest Rate Risk arises when the change in the market interest rates adversely affect the bank's financial condition by hitting its profits. The immediate impact of changes in interest rates is on bank's earnings (i.e. reported profits) by changing its Net Interest Income (NII) and Net Interest Margin (NIM). A long-term impact of changing interest rates is on bank's Market Value of Equity (MVE) or Net Worth because the economic value of bank's assets, liabilities and off-balance sheet positions get affected due to fluctuations in market interest rates. The Interest Rate Risk can be viewed from 2 perspectives:

Earnings Perspective

The risk from the earnings perspective is measured by changes in the bank's Net Interest Margin (NIM) and Net Interest Income (NII). There are many techniques for measuring the same such as Gap Analysis, Duration Gap Analysis, Simulation, Value at Risk (VaR) and so on.

Traditional Gap Analysis

The focus of the Traditional Gap Analysis is to measure the level of a bank's exposure to interest rate risk in terms of sensitivity of its NII to interest rate movements. It involves bucketing of all Rate Sensitive Assets (RSA) and Rate Sensitive Liabilities (RSL) and off balance sheet items as per their residual maturity/re-pricing date in various time bands. It may also involve computing Earnings at Risk (EaR) i.e. loss of income under different interest rate scenarios over a time horizon of one year. In every time bucket given by RBI, the RSA and RSL are computed and the positive or negative Gap is found out.

Hence, if the bank feels that the interest rates are going to rise under the current scenario, it is favourable for the bank to maintain a positive Gap and if it feels that the interest rates are going to decline in the near future, it is favourable for the bank to maintain a negative Gap.

Economic Value Perspective - Duration Gap Analysis (DGA)

The focus of the DGA is to measure the bank's exposure to interest rate risk in terms of sensitivity of Market Value of its Equity (MVE) to interest rate fluctuations. The DGA involves bucketing of all RSA and RSL same as done in Traditional Gap analysis and computing the Modified Duration Gap (MDG). This can be used to evaluate the impact on the MVE of the bank under different interest rate scenarios. Modified Duration (MD) of an asset or liability measures the approximate percentage change in its value for a 1% change in the rate of interest. The larger the Modified Duration Gap, the more is the bank exposed to interest rate shocks.

Interest Rate Sensitivity Time Buckets

Earlier, the maximum bucket for sensitive items was over 5 years, but it has been revised now to 'Over 5 yrs', 5 yrs to 7 yrs, 7 yrs to 10 yrs, 10 yrs to 15 yrs and over 15 yrs as the banks have forayed greatly into long term assets like home loans, infrastructure loans and so on which have a maturity well in excess of 5 years.

ASSET LIABILITY MANAGEMENT AT STATE BANK OF INDIA (SBI)

The Asset and Liability Management Committee of the bank (ALCO) is given the primary role of Liquidity Management and Interest Rate Risk Management. ALM department provides various data, reports and information to ALCO to enable them to monitor the same and provide necessary guidelines. The Global Market Department gets the various reports, data from Asset Liability Management Department on a daily basis and takes decisions regarding liquidity management and interest rates on various instruments in consultation with ALCO. ALCO can meet as and when required but at least once in a month.

ALCO

The Asset -Liability Management committee (ALCO) presently has the following members: Managing Director & Chief Credit and Risk Officer Managing Director & Group Executive (Associates & Subsidiaries) Deputy Managing Director & Group Executive (Global Markets) Deputy Managing Director & Group Executive (Mid Corporate) Deputy Managing Director & Group Executive (National Banking) Deputy Managing Director (Corporate Strategy and New Business) Deputy Managing Director & Group Executive (Rural Business) Deputy Managing Director & Chief Financial Officer - Chairman Deputy Managing Director & Group Executive(Corporate Banking) Deputy Managing Director & Group Executive (International Banking) Chief General Manager (Financial Control) - Member Secretary

LIQUIDITY RISK MANAGEMENT AT SBI

The bank measures the mismatches in cash inflow and cash outflow by calculating the Maturity Gap Analysis over several time buckets. While computing the gap, assets (inflow)/liabilities (outflow) are placed as per their remaining maturities. In the case of assets/liabilities without any contractual maturity (SB/CA/CC etc.,) the maturity patterns are based on behavioral study of these portfolios with the approval of ALCO. A large portion (presently taken as 40%) of retail term deposits due for maturity are assumed to be rolled over and accordingly put in longer time bucket of outflow. Similarly a small portion of our Non Fund-Based business (for LC 5% and for BG 1.5%) are assumed to devolve and placed in outflows across several buckets. For example, Current Account and Savings Account balances are bifurcated into core and volatile portions and volatile portion is placed in the short-term buckets while core portion is placed in longer term buckets of outflow. This gap analysis has to be done on daily basis but reported to RBI on 1st and 3rd Wednesdays of every month. RBI has prescribed limits only for negative net cumulative mismatches in the first 4 buckets in short-term period (5% for 1 day, 10% in 2-7 days, 15% for 8-14 days, 20% in 15-28 days). ALCO has however prescribed the upper limit of 20% for all other time buckets. Structural Liquidity report is compiled as above on a daily basis and put up to top management {CGM (FC) and DMD & CFO}.

Liquid Assets to Total Assets Range Liquid Assets to Total Deposits Range Liquid Assets to Near Short-Term Liabilities >100% No regulatory definition of liquid Assets and benchmarks. Accordingly, liquid assets are defined internally and the benchmarks are set matching with these definitions keeping in view with the bank's risk appetite The definition of liquidity ratios that are monitored and the bench marks are approved by ALCO. ALM Department monitors these ratios

INTEREST RATE RISK MANAGEMENT AT SBI

The Gap Analysis statements prepared daily by ALM department and sent to Global Markets Department. Also, list of all deposit and lending rates of all commercial banks is prepared daily and sent to Global Markets Department, who may take decisions on changes in interest rates. Details of Growth in Advances and Deposits prepared daily and sent to Global Markets Department, who may look at the market conditions, the need for the bank and tweak rates on things like bulk deposits almost every day. The major changes in interest rates are done in consultation with ALCO.

CONTINGENCY FUNDING PLAN (CFP)

RBI guidelines say that all banks must prepare a contingency plan to measure the ability to withstand any unexpected liquidity crisis.

CONCLUSION

The Asset-Liability Management is one of the most crucial functions of a bank in the highly competitive and complex business environment today. Asset-Liability Management is a co-ordinated management of a bank's balance sheet to allow for different interest rate, liquidity and optionality shocks. ALM involves quantification of various market risks and conscious decision making with regard to asset liability structure in order to maximize interest earnings within the frame work of perceived risks. The apex governing body for commercial banks in India, RBI has given certain guidelines for ALM and the banks have to follows these to prepare the Structural Liquidity Statements and Interest Rate Sensitivity Statements. The Indian economy, as a whole has been facing liquidity crunch in the banking system due to large outgo of funds to Government due to 3G and Broadband auctions and Disinvestment initiatives by Government. Also, the deposit growth has been very low as compared to credit growth in banks due to negative real rate of return offered by bank deposits in current high inflationary scenario. This has meant negative liquidity mismatch for the banks, who have had to resort to short term Repo borrowings to fund their credit growth, leading to very high Credit-to-Deposit Ratios, which is a serious cause of concern as highlighted by RBI in its Monetary Policy Review.

This has led to increase in deposit rates by most banks to attract fresh deposits from public. State Bank of India is the largest bank in India, having a very elaborate and complex ALM process. The Contingency Funding Plan (CFP) is also quite comprehensive and the Quarter 3 results showed that the ALM at SBI has been quite successful in keeping its NIM above 3%, CASA at more than 45% and CAR in excess of 13%. The only cause of concern has been the provisions made on NPA's, which have hit the bank's profits a little bit. And, still the Provision Coverage Ratio is below the stipulated limit of 70%, which means that huge provisions will have to made in the ongoing quarter as well, leading to lower profitability for the bank. SBI has also increased its deposit rates in the past 2 months to attract fresh deposits, which has been the case with all other banks. SBI hopes to bring its credit growth and deposit growth closer to each other in the ongoing and coming quarters to make its Asset-Liability position better and reduce its Credit-to-Deposit ratio, which is slightly higher than a tolerable level at present. Hence, Asset-Liability Management comes with its various challenges and complexities, but a bank has to give a lot of importance to this task, as it has a direct impact on a bank's profitability and sustainability.

Cite this page