of 28
8/13/2019 94778973 Asset and Liability Management in Indian Banks
1/28
ASSET AND LIABILITY MANAGEMENT IN INDIAN BANKS:
A STUDY OF SELECT BANKS
Introduction:
Asset-Liability Management (ALM) is concerned with strategic management of assetsand liabilities of banks, against risks caused by changes in the liquidity position of the
bank, interest rates, and exchange rates, and against credit risk and contingency risk An
effecti!e ALM technique aims to manage the !olume, mix, maturity, rate sensiti!ity,
quality and liquidity of the assets and liabilities as a whole so as to attain a predetermined
acceptable risk"reward ratio #he purpose of ALM is to enhance the asset quality,
quantify the risks associated with the assets and liabilities and further manage them, in
order to stabili$e the short-term profits, the long-term earnings and the long-run
sustenance of the bank
#he importance of Asset Liability Management in %ndian &anks is growing at a rapid
pace %ndian &anks are now emphasi$ing more on Asset Liability Management as ameans of sound financial management of &anking 'perations #he eser!e &ank of
%ndia (&%) has implemented the &asel %% norms for the regulation of %ndian banks which
pro!ided a framework for banks to de!elop sound ALM policies #he present study
analyses asset-liability management practices in %ndian banks in the context of guidelines
pro!ided by the eser!e &ank of %ndia
Indian banking indutr!:
#he %ndian banking sector has emerged as one of the strongest dri!ers of %ndias
economic growth #he banking system of %ndia should not only be hassle free but it
should be able to meet new challenges posed by the technology and any other externaland internal factors *ost %ndependence era, %ndias banking system has se!eral
outstanding achie!ements to its credit #he most striking is its extensi!e reaches not only
metropolitans or cosmopolitans but e!en to the remote corners of the country #his is one
of the main reasons of %ndias growth process
#he history of %ndian &anking +ystem can be segregated into three distinct phases #hey
are as mentioned below
"#a$ I "r$%Nationa&i'ation $ra: arly phase from ./01 to .212 of %ndian &anks
"#a$ II Nationa&i'ation tag$:3ationali$ation of %ndian &anks and up to .22. prior
to %ndian banking sector eforms "#a$ III "ot &ib$ra&i'ation $ra: 3ew phase of %ndian &anking +ystem with the
ad!ent of %ndian 4inancial 5 &anking +ector eforms after .22. and Liberali$ation
1
8/13/2019 94778973 Asset and Liability Management in Indian Banks
2/28
"#a$ I
#he 6eneral &ank of %ndia was set up in the year ./01 #he ast %ndia 7ompany
established &ank of &engal (.082), &ank of &ombay (.098) and &ank of Madras (.09:)
as independent units and called it *residency &anks #hese three banks were
amalgamated in .2;8 and %mperial &ank of %ndia was established which started as pri!ate
shareholders banks, mostly uropeans shareholders
%n .01< Allahabad &ank was established and first time exclusi!ely by %ndians, *un=ab
3ational &ank Ltd was set up in .029 with headquarters at Lahore &etween .281 and
.2.:, &ank of %ndia, 7entral &ank of %ndia, &ank of &aroda, 7anara &ank, %ndian &ank,
and &ank of Mysore were set up eser!e &ank of %ndia came in .2:uring the first
phase the growth was !ery slow and banks also experienced periodic failures between
.2.: and .290 #here were approximately ..88 banks, mostly small #o streamline the
functioning and acti!ities of commercial banks, the 6o!ernment of %ndia came up with
#he &anking 7ompanies Act, .292 which was later changed to &anking egulation Act
.292 as per amending Act of .21< (Act 3o ;: of .21uring those days public has lesser confidence in the banks As an
aftermath deposit mobili$ation was slow 3ot only that #he banks were selecti!e in
in!iting the customers for transacting with tbe banks 'nly those wealthy and strong
financial backgrounds were in!ited to be part of the clientele for the banks Abreast of it
the sa!ings bank facility pro!ided by the *ostal department was comparati!ely safer
Moreo!er, funds were largely gi!en to traders
"#a$ II
6o!ernment took ma=or steps in this %ndian &anking +ector eform after independence%n .2
8/13/2019 94778973 Asset and Liability Management in Indian Banks
3/28
.292 nactment of &anking egulation Act
.2
8/13/2019 94778973 Asset and Liability Management in Indian Banks
4/28
and liabilities it holds or its mix and !olume %n addition, ALM requires an understanding
of the market area in which the bank operates
#he framework of asset-liability management broadly co!ers area of interest rate risk,
liquidity risk, exchange risk and credit risk ALM can be defined as an operation for
assessing the abo!e mentioned risks, acti!ely altering the asset-liability portfolio, and forstrategically taking actions and managing risks with the ob=ecti!e of maximi$ing
profits ALM is not limited to on balance sheet assets and liabilities such as deposits and
lendings only, but also includes off Cbalance sheet acti!ities such as swaps, futures andoptions #he ob=ecti!e of ALM is to make banks fully prepared to face the emerging
challenges
"ur(o$ and ob*$cti+$ o) ALM:
e!iew the interest rate structure and compare the same to the interest"productpricing of both assets and liabilities
xamine the loan and in!estment portfolios in the light of the foreign exchangerisk and liquidity risk that might arise
xamine the credit risk and contingency risk that may originate either due to ratefluctuations or otherwise and assess the quality of assets
e!iew, the actual performance against the pro=ections made and analy$es the
reasons for any effect on spreads
Aim is to stabili$e the short-term profits, long-term earnings and long-term
substance of the bank #he parameters that are selected for the purpose of
stabili$ing asset liability management of banks are -3et %nterest %ncome (3%%)
-3et %nterest Margin (3%M)
-conomic quity atio
T#$ N$c$it! o) A$t Liabi&it! Manag$,$nt in Indian bank
ALM is introduced in %ndian &anking industry from .stApril, .222 ALM is concerned
with risk management and pro!ides a comprehensi!e and dynamic frame work for
measuring, monitoring and managing liquidity, interest rate, foreign exchange and equityand commodity price risks of a bank that needs to be closely integrated with the banks
business strategy
#he asset-liability management in the %ndian banks is still in its nascent stage Dith the
freedom obtained through reform process, the %ndian banks ha!e reached greater hori$onsby exploring new a!enues #he go!ernment ownership of most banks resulted in a
carefree attitude towards risk management #his complacent beha!ior of banks forced the
eser!e &ank to use regulatory tactics to ensure the implementation of the ALM Also,
the post-reform banking scenario is marked by interest rate deregulation, entry of new
pri!ate banks, and gamut of new products and greater use of information technology #o
cope with these pressures banks were required to e!ol!e strategies rather than ad hoc fire
4
8/13/2019 94778973 Asset and Liability Management in Indian Banks
5/28
fighting solutions %mprudent liquidity management can put banks earnings and
reputation at great risk #hese pressures call for structured and comprehensi!e measures
and not =ust contingency action #he Management of banks has to base their business
decisions on a dynamic and integrated risk management system and process, dri!en by
corporate strategy &anks are exposed to se!eral ma=or risks in the course of their
business C credit risk, interest rate risk, foreign exchange risk, equity " commodity pricerisk, liquidity risk and operational risk %t is, therefore, important that banks introduce
effecti!e risk management systems that address the issues related to interest rate,
currency and liquidity risks
I,(&$,$ntation o) ALM !t$,
%n .22:-29 &% asked public sector banks to frame the ALM policy &ut, first e!er
comprehensi!e circular for establishing ALM system was issued by &% on .2 4eb,.222 According to this circular the process of ALM rest on : pillars
. ALM %nformation systems
Management %nformation +ystem
%nformation a!ailability, accuracy, adequacy and expediency
; ALM 'rgani$ation
+tructure and responsibilities
Le!el of top management in!ol!ement
: ALM *rocess
isk parameters
isk identification
isk measurement
isk management
isk policies and tolerance le!els
ALM Organi'ation:
#he Asset - Liability 7ommittee (AL7') consisting of the bankEs senior managementincluding 7' should be responsible for ensuring adherence to the limits set by the
&oard as well as for deciding the business strategy of the bank (on the assets and
liabilities sides) in line with the bankEs budget and decided risk management ob=ecti!es
#he ALM desk consisting of operating staff should be responsible for analy$ing,monitoring and reporting the risk profiles to the AL7' #he staff should also prepare
forecasts (simulations) showing the effects of !arious possible changes in marketconditions related to the balance sheet and recommend the action needed to adhere to
bankEs internal limits
#he AL7' is a decision making unit responsible for balance sheet planning from risk -
return perspecti!e including the strategic management of interest rate and liquidity risks
5
8/13/2019 94778973 Asset and Liability Management in Indian Banks
6/28
ach bank will ha!e to decide on the role of its AL7', its responsibility as also the
decisions to be taken by it #he business and risk management strategy of the bank should
ensure that the bank operates within the limits " parameters set by the &oard #hebusiness issues that an AL7' would consider, inter alia, will include product pricing for
both deposits and ad!ances, desired maturity profile of the incremental assets and
liabilities, etc %n addition to monitoring the risk le!els of the bank, the AL7' shouldre!iew the results of and progress in implementation of the decisions made in the
pre!ious meetings #he AL7' would also articulate the current interest rate !iew of the
bank and base its decisions for future business strategy on this !iew %n respect of thefunding policy, for instance, its responsibility would be to decide on source and mix of
liabilities or sale of assets #owards this end, it will ha!e to de!elop a !iew on future
direction of interest rate mo!ements and decide on a funding mix between fixed !s
floating rate funds, wholesale !s retail deposits, money market !s capital marketfunding, domestic !s foreign currency funding, etc %ndi!idual banks will ha!e to decide
the frequency for holding their AL7' meetings
ALM In)or,ation S!t$, ALM %nformation +ystem is used for the collection ofinformation accurately, adequately and expeditiously %nformation is the key to the ALM
process A good information system gi!es the bank management a complete picture ofthe banks balance sheet
ALM "roc$ #he basic ALM process in!ol!es identification, measurement andmanagement of risk parameters #he &% in its guidelines has asked %ndian banks to use
traditional techniques like 6ap Analysis for monitoring interest rate and liquidity risk
Fowe!er &% is expecting %ndian banks to mo!e towards sophisticated techniques like
>uration, +imulation, Ba in the future
Manag$,$nt o) -ik in ALM
#he risk management is a complex function and it requires speciali$ed skills and
expertise &anks ha!e been mo!ing towards the use of sophisticated models for
measuring and managing risks Large banks and those operating in international markets
should de!elop internal risk management models to be able to compete effecti!ely with
their competitors As the domestic market integrates with the international markets, the
banks should ha!e necessary expertise and skill in managing !arious types of risks in a
scientific manner #he design of risk management functions of the bank dictated by the
si$e, complexity of functions, the le!el of technical expertise and the quality of M%+
%nternationally adopted committee approaches for the risk management are the Asset-Liability Management 7ommittee (AL7')deals with different types of market riskG the
7redit *olicy 7ommittee (7*7)o!ersees the credit"counterparty risk and country risk
isk can be defined as the chance or the probability of loss or damage %n the case of
banks, these include credit risk, capital risk, market risk, interest rate risk and the
liquidity risk +ince financial institutions like banks ha!e complexities and frequent
changes in their operating en!ironments, these kinds of risks require more focus
6
8/13/2019 94778973 Asset and Liability Management in Indian Banks
7/28
Mark$t -ik Manag$,$nt: Market risk refers to the uncertainty of future earningsresulting from changes in interest rates, exchange rates, market prices and !olatilities
#he &ank assumes market risk from consumer and corporate loans, position taking, and
trading and in!estment acti!ities
#he strategy for controlling market risk shall in!ol!e
+tringent control and limits
+trict segregation of front and back office duties
>aily reporting of positions
egular independent re!iew of all controls and limits
igorous testing and auditing of all pricing, trading, risk management and
accounting systems
a. Trading -ik
#he &ank conducts some trading acti!ities on behalf of its customers, but also trades forits own account #rading portfolios shall be managed with the intent to buy and sell
financial instruments o!er a short period of time rather that hold positions for
in!estments 7ontinued enhancement of the &anks trading risk management systems andprocesses will be kept up-to-date with market de!elopments
#rading on behalf of customers will be done only for securities listed on the +ecurities
xchange, including bonds, treasury bills and shares +uch trading will be done by the
&anks Licensed epresentati!e under the super!ision of the Licensed *rincipal #herewill be no limit for trades done on behalf of customers +ecurities, whether listed on the
+ecurities xchange or not, traded on the &anks own account will be traded by the
&anks Licensed epresentati!e under the super!ision of the Licensed *rincipal but will
be authori$ed by the &anks officers in accordance with established in!estments limits
>aily reports of profit and loss, limit o!erruns and compliance will be circulated to all
appropriate departments and management for e!aluation igorous analysis and testing
programs will be applied to measure risk, and to !erify accuracy of !arious controls andlimits #hese will include stress testing, and sensiti!ity analysis
b. For$ign E/c#ang$ -ik
#he operational currency of the &ank is the 7 >ollar Fowe!er, in order to meet
customer needs, the &ank buys and sells a number of foreign currencies, holds assets and
liabilities denominated in se!eral foreign currencies and also as a result of its in!estmentsin foreign currencies and its international trading acti!ities, the &ank recei!es income and
pays expenses in foreign currency #he &ank is therefore exposed to foreign exchange
risk associated with the effect of fluctuations in the rates of exchange in !arious
7
8/13/2019 94778973 Asset and Liability Management in Indian Banks
8/28
currencies #o mitigate the risk of loss due to rate changes the &ank will match its
positions as closely as possible
Int$r$t -at$ -ik ,anag$,$nt:
#he function of ALM is not =ust protection from risk #he safety achie!ed through ALMalso opens up opportunities for enhancing net worth %nterest rate risk (%) largely poses
a problem to a banks net interest income and profitability 7hanges in interest rates cansignificantly alter a banks net interest income (3%%), depending on the extent of
mismatch between the asset and liability interest rate reset times 7hanges in interest rates
also affect the market !alue of a banks equity, earnings, !alue of assets, liability, off-balance sheet items and cash flow Fence, the ob=ecti!e of interest rate risk management
is to maintain earnings, impro!e the capability, ability to absorb potential loss and to
ensure the adequacy of the compensation recei!ed for the risk taken and affect risk returntrade-off
Methods of managing % first require a bank to specify goals for either the book !alueor the market !alue of 3%% the focus will be on the current !alue of 3%% and latter on the
market !alue of equity %n either case, though, the bank has to measure the risk exposure
and formulate strategies to minimi$e or mitigate risk
#he immediate focus of ALM is interest-rate risk and return as measured by a banks
3%M, 3%%
3%M H (3%%" arning assets)3%%H (%nterest income C %nterest expense)
A banks 3%M, in turn, is a function of the interest-rate sensiti!ity, !olume, and mix of its
arning assets and liabilities #hat is, 3%M H f (ate, Bolume, Mix)
ffects of interest rate risk
7hanges in interest rates can ha!e ad!erse effects both on a banks earnings and itseconomic !alue
#he earnings perspecti!e 4rom the earnings perspecti!e, the focus of analyses is theimpact of changes in interest rates on accrual or reported earnings Bariation in earnings
(3%%) is an important focal point for % analysis because reduced interest earnings will
threaten the financial performance of an institution
conomic !alue perspecti!e Bariation in market interest rates can also affect the
economic !alue of a banks assets, liabilities, and 'ff &alance +heet ('&+) positions+ince the economic !alue perspecti!e considers the potential impact of interest rate
changes on the present !alue of all future cash flows, it pro!ides a more comprehensi!e
!iew of the potential long-term effects of changes in interest rates than is offered by the
earnings perspecti!e #he economic !alue perspecti!e identifies risk arising from long-term interest rate gaps
8
8/13/2019 94778973 Asset and Liability Management in Indian Banks
9/28
conomic Balue perspecti!e in!ol!es analy$ing the expected cash inflows on assets
minus expected cash outflows on liabilities plus the net cash flows or off-balance sheet
items
&anking industry in %ndia has substantially more issues associated with interest rate risks,
which is due to circumstances outside its control #his poses extra challenges to thebanking sector '!er the time Asset-Liability Managers ha!e de!eloped a number of
different ways to quantify the risk being taken #hese include
(i) Maturity +ince it takes into account only the timing of the final principal
payment, maturity is considered as approximate measure of risk and in a sense
does not quantify risk
(ii) >uration is the weighted a!erage time of all cash flows, with weights being thepresent !alues of cash flows %t can again be used to determine the sensiti!ity of
prices to change in interest rates
(iii) 7on!exity &ecause of a change in market rates and passage of time, duration may
not remain constant Dith each successi!e basis point mo!ement downward, bondprices increases at an increasing rate +imilarly, if rate increase, the rate of decline
of bond prices declines #his property is called con!exity
T#$ +ariou t!($ o) int$r$t rat$ rik ar$ id$nti)i$d a )o&&o0:
6ap"Mismatch risk %t arises from holding assets and liabilities and off balance sheet
items with different principal amounts, maturity dates 5 re-pricing dates thereby creating
exposure to unexpected changes in the le!el of market interest rates
&asis isk %t is the risk that the %nterest rat of different Assets"liabilities and off balance
items may change in different magnitude #he degree of basis risk is fairly high in respect
of banks that create composite assets out of composite liabilities
mbedded option isk 'ption of pre-payment of loan and 4ore- closure of deposits
before their stated maturities constitutes embedded option risk
Iield cur!e risk Mo!ement in yield cur!e and the impact of that on portfolio !alues and
income
e price risk Dhen assets are sold before maturities
ein!estment risk ?ncertainty with regard to interest rate at which the future cash flowscould be rein!ested
3et interest position risk Dhen banks ha!e more earning assets than paying liabilities,net interest position risk arises in case market interest rates ad=ust downwards
T$c#ni1u$ )or ,$auring $/(our$ o) bank to int$r$t rat$ rik
9
8/13/2019 94778973 Asset and Liability Management in Indian Banks
10/28
%ndian banks use the con!entional gap reporting methodology for asset liability
management for measuring interest rate risk from the earnings perspecti!e 6ap is the
measurement of the difference between risk sensiti!e assets and risk sensiti!e liabilities
Int$r$t rat$ $niti+it! and GA" ,anag$,$nt:
#his model measures the direction and extent of asset-liability mismatch through a
funding or maturity 6A* (or, simply, 6A*) Assets and liabilities are grouped in thismethod into time buckets according to maturity or the time until the first possible
resetting of interest rates 4or each time bucket the 6A* equals the difference between
the interest rate sensiti!e assets (+As) and the interest rate sensiti!e liabilities (+Ls)%n symbols 6A* H +As C +Ls
Dhen interest rates change, the banks 3%% changes based on the following
interrelationshipsJ3%% H (+As - +Ls) x Jr
J3%% H 6A* x Jr
%nterrelationship between 6A* and J3%%
+lno #ype of 6A* 7hange in interest rates
(Jr)
7hange in 3%%
(J3%%) ))((NII)
(NII)NII
. +A H +Ls %ncrease 3o 7hange
; +A H +Ls >ecrease 3o 7hange
: +As K +Ls %ncrease 3%% increases
9 +As K +Ls >ecrease 3%% decreases
< +As +Ls %ncrease 3%% decreases
1 +As +Ls >ecrease 3%% increases
Dhen +AH+L, 6A*H8G indicates A $ero 6A* will be the best interest- sensiti!e 6A*
position either if the bank is unable to speculate interest rates accurately or if its capacity
to absorb risk is close to $ero Dith a $ero 6A*, the bank is fully protected against bothincreases and decreases in interest rates as its 3%% will not change in both cases
Dhen +As K +Ls, *ositi!e 6A*,
Dhen +As +Ls, 3egati!e 6A*,
%n both the cases either 3%% may increase or decrease
As a tool for managing %, 6A* management suffers from three limitations
4inancial institutions in the normal course are incapable of out-predicting the markets,
hence maintain the $ero 6A* %t assumes that banks can flexibly ad=ust assets and liabilities to attain the desired 6A*
%t focuses only on the current interest sensiti!ity of the assets and liabilities, and ignores
the effect of interest rate mo!ements on the !alue o bank assets and liabilities
Cu,u&ati+$ GA" ,od$&
10
8/13/2019 94778973 Asset and Liability Management in Indian Banks
11/28
%n this model, the sum of the periodic 6A*s is equal to the cumulati!e 6A* measured by
the maturity 6A* model Dhile the periodic 6A* model corrects many of thedeficiencies of the 6A* model, it does not explicitly account for the influence of multiple
market rates on the interest income
Duration GA" ,od$& 2DAGA"3
%n order to shift the bankEs focus to the economic !alue perspecti!e and to upgrade theALM system, the duration gap analysis was suggested by the eser!e &ank of %ndia
(&%) in its circular of ./ April ;881 Dith the margin for interest rates to fluctuate o!er
time, and the need for banks to obtain expertise in handling management information
systems (M%+), it would become necessary for banks to adopt an impro!ed ALM systemand more sophisticated techniques such as the duration gap analysis
>uration is defined as the a!erage life of a financial instrument %t also pro!ides an
approximate measure of market !alue interest elasticity #he duration gap methodology
should be implemented by calculating the modified duration of all assets and liabilitiesand the off-balance sheet items for a bank Fere, the weighted a!erage duration of assets
and weighted a!erage duration of liabilities are used to measure the interest rate risk&anks need to compute the duration gap as prescribed by the &%
>uration is a measure of percentage change in the economic !alue of a position that willoccur gi!en a small change in the le!el of interest rates
>ifference between duration of assets and liabilities is banks net duration
%f >AN>L, a decrease in interest rate will increase the MB of the bank
%f >LN>A, an increase in interest rate will increase the MB of the bank and a decreasein interest rate will decrease the MB of the bank
>uration 6ap Analysis recogni$es the time !alue of money
%t fails to recogni$e basis risk as it assumes parallel shift in yield cur!e
>uration gap (>6A*) H Deighted a!erage modified duration of assets - Deight O
Deighted a!erage modified duration of liabilities
Dhere Deight H isk sensiti!e liabilities"isk sensiti!e assets
Deighted a!erage duration of asset A. H Deight A. O MacaulayEs duration of asset A.
Dhere Deight of an asset H Market !alue of asset ."Market !alue of total assets
#otal weighted a!erage duration of assets H +um of weighted a!erage duration of
indi!idual assets
Deighted a!erage duration of liability A. H Deight A. O MacaulayEs duration of liability
A.
Dhere Deight of liability H Market !alue of liability ."Market !alue of total liabilities
11
8/13/2019 94778973 Asset and Liability Management in Indian Banks
12/28
#otal weighted a!erage duration of liabilities H +um of weighted a!erage duration of
indi!idual liabilities
Modified duration of equity H >6A* x Le!erage
Le!erage H isk sensiti!e liabilities"quity
%f the duration of assets is greater than the duration of the liabilities, then a rise in the
interest rate will cause the market !alue of equity to fall #he market !alue of equity
denotes the long-term profits of a bank #he bank will ha!e to minimi$e unfa!orablemo!ement in this !alue due to interest rate fluctuations #he traditional gap method
ignores how changes in interest rates affect the market !alue of the bankEs equity
Si,u&ation ana&!i
+imulations ser!e to construct the risk-return profile of the banking portfolio #his model
helps to introduce a dynamic element in the analysis of interest rate risk +imulation
models utili$e computer power to pro!ide DFA# %4 scenarios %t is !ery important to
combine technical expertise with an understanding of issues in the organi$ationAccuracy of data and reliability of the assumption made are certain requirement for a
simulation model to succeed
+imulation technique attempts to o!ercome the limitation of 6A* and >uration
approaches by computer modeling the banks interest rate sensiti!ity #he modelingmakes assumptions about future path of interest rates, shape of yield cur!e, changes in
business acti!ity, pricing and hedging strategies
Li1uidit! and Fund Manag$,$nt:
Liquidity is measured in terms of ha!ing sufficient funds a!ailable at all times, to meetfully and promptly, the legitimate demands for money made on the bank arising from
deposit withdrawal, presentation of cheques, maturing in!estments, draws undercommitted loan facilities, and other financial commitments #he &ank needs to assure
depositors that they can withdraw their funds when desired, borrowers of the a!ailability
of funds to meet legitimate demands for credit expansion, and employees of the bankstability 5 longe!ity %t must be remembered howe!er that too much liquidity will ha!e a
negati!e impact on profitability, while too little liquidity will increase the risk of
insol!ency #he &ank is deemed to ha!e adequate liquidity when it can obtain sufficient
cash promptly and at a reasonable rate (cost) #he determination of the adequacy of the&anks liquidity position depends upon an analysis of the &anks position relati!e to the
following factors
historical funding requirements
current liquidity position
anticipated future funding needs
present and anticipated asset quality
12
8/13/2019 94778973 Asset and Liability Management in Indian Banks
13/28
present and future earnings capacity
sources of funds
Li1uidit! -ik
Liquidity risk is the risk of ha!ing to fund some assets by the acquisition of additional
funds under unfa!orable market terms #his might occur when unexpected clearing drains
occur in close proximity, when depositors are lea!ing the bank due to a perception ofincreased risk, or when loan growth is !ery strong
Liquidity risk is the potential inability of a bank to meet its payment obligations in a
timely and cost effecti!e manner %t arises when the bank is unable to generate cash to
cope with a decline in deposits"liabilities or increase in assets
#he Asset Liability Management (ALM) is a part of the o!erall risk management system
in the banks %t implies examination of all the assets and liabilities simultaneously on acontinuous basis with a !iew to ensuring a proper balance between funds mobili$ationand their deployment with respect to their a) maturity profiles, b) cost, c) yield, d) risk
exposure, etc %t includes product pricing for deposits as well as ad!ances, and the desired
maturity profile of assets and liabilities
#olerance le!els on mismatches should be fixed for !arious maturities depending upon
the asset liability profile, deposit mix, nature of cash flow etc &ank should track the
impact of pre-payment of loans 5 premature closure of deposits so as to realisticallyestimate the cash flow profile
#he liquidity risk in banks manifest in different dimensions
Funding -ikC %t is the need to replace net outflows due to unanticipated
withdrawals"non-renewal of deposits (wholesale and retail)
Ti,$ -ikC %t is the need to compensate for non-receipt of expected inflows of funds,
ie performing assets turning into non-performing assetsG and
Ca&& -ikC %t happens due to crystalli$ation of contingent liabilities and unable to
undertake profitable business opportunities when desirable
&% recommended Asset liability management system for measuring cash flow
mismatches at different time bands &anks should ha!e to analy$e the beha!ioral maturity
profile of !arious components of on " off-balance sheet items on the basis of assumptions
and trend analysis supported by time series analysis &anks should also undertake
!ariance analysis, at least, once in six months to !alidate the assumptions #he
assumptions should be fine-tuned o!er a period which facilitates near reality predictions
about future beha!ior of on"off-balance sheet items
13
8/13/2019 94778973 Asset and Liability Management in Indian Banks
14/28
atios #he AL7' will monitor the &ankEs liquidity position by re!iewing the following
measures
. 7ash reser!e Minimum 1 ; Liquid assets ;8 - ;1 : Loans">eposits /8 - 08
#he cash reser!e ratio is calculated by expressing cash reser!es (comprising local cashand net balances with the 7entral &ank) as a percentage of total deposits #he &anking
Act requires that commercial banks hold 1 of their deposits with the 7entral &ank #he
liquid assets ratio is calculated as liquid assets expressed as a percentage of total deposits,and the 7entral &ank guidelines pro!ide that this should be between ;8 and ;
8/13/2019 94778973 Asset and Liability Management in Indian Banks
15/28
deposits, maturity distribution of time deposits and rates paid compared to rates offered
by competitors
In+$t,$nt:
%n!estments purchased will be consistent with a separate written in!estment policy #heob=ecti!es of the in!estment policy are to (.) pro!ide liquidity (;) pro!ide for interest rate
risk management, and (:) pro!ide additional profit #he in!estments portfolio shall be
di!ersified to minimi$e the risk of loss resulting from o!er concentration of assets inspecific class, currency, 7ountry, or economic sector
#he &ank shall adopt a flexible weightings approach (strategic asset allocation) in!ol!ing
the periodic ad=ustments of the weights for each category based either on the market
analysis or on technical analysis (ie, market timing) A new allocation therefore may beconstructed to capture greater returns in a changing market #he initial allocation is as
follows7lass %nitial Allocation 3ew Allocation +hort-term in!estments (Money Market)
8/13/2019 94778973 Asset and Liability Management in Indian Banks
16/28
proposals All exceptions to the credit policy of the &ank, or credits outside of the
authority of the 7redit 7ommittee, must be referred to the xecuti!e 7ommittee for its
decision or recommendation to the &oard of >irectors Figher risk exposures are sub=ectto mandatory referral to the &oard of >irectors
7redit lines for off-balance sheet instruments such as credit card limits, letters of creditand guarantee, shall be managed as an integral part of the same processAt least annually,
banking officers will meet formally with each commercial client to re!iew their financialaffairs and to assess the appropriateness of their credit requirements #he results will be
formulated into a presentation which will be ad=udicated in the same manner as a new
credit Dhere unusual risks exist, credits will be re!iewed more frequently %n this way,the &ank will remain fully aware of customers risk profiles isk ratings will be
reassessed with each credit presentation or re!iew
#o minimi$e risk the &ank will only accept those credits where there is reasonable
confidence that the asset will be redeemed at face !alue
Limits and maximum maturity periods for !arious types of loans will be outlined in the
&anks 7redit *olicy
-ik Di+$ri)ication
#he &anks credit policies and limits are intended to ensure broad di!ersification across
!arious types of credit risk Limits will be set for indi!idual borrowers, particularindustries and certain types of lending #here !arious risks will be determined taking into
account the relati!e risk of the borrower, economic acti!ity or product type
"ricing )or -ik
#he &ank will classify loans into risk categories by economic sector and by product and
will price the loans to compensate for the risk in!ol!ed
Accounting )or "rob&$, Loan
#he &oard of >irectors understands that in any portfolio there will be delinquent loanswhich require special accounting procedures #he &ank has therefore adopted the 7entral&ank *rudential 6uidelines with respect to loan re!iew, loan classification, loan
pro!isioning, and suspension of interest and loan write-offs #he guidelines require an
annual re!iew of at least /8 of the &anks credit portfolio taking into considerationG theterms of the loan, the business of the borrower, e!aluation of the pro=ect being financed,
security, and debt ser!ice #he loans are classified into fi!e categories pass, special
mentioned, substandard, doubtful, and loss Any loan classified as substandard, doubtful
16
8/13/2019 94778973 Asset and Liability Management in Indian Banks
17/28
or loss requires a pro!ision of .8,
8/13/2019 94778973 Asset and Liability Management in Indian Banks
18/28
so as to ensure that all ma=or credit risks embedded in the balance sheet ha!e been
tracked
So,$ o) t#$ co,,on&! u$d ,$t#od to ,$aur$ cr$dit rik ar$:
atio of non performing ad!ances to total ad!ancesG
atio of loan losses to bad debt reser!esG
atio of loan losses to capital and reser!esG
atio of loan loss pro!isions to impaired creditG
atio of bad debt pro!ision to total income
O($rationa& -ik ,anag$,$nt:
P'perational isk is defined as the risk of direct or indirect loss resulting from
inadequate or failed internal processes, people and system or from external e!entsQ
operational risk is defined as any risk, which is not categori$ed as market or credit risk, or
the risk of loss arising from !arious types of human or technical error %t is also
synonymous with settlement or payments risk and business interruption, administrati!e
and legal risks 'perational risk has some form of link between credit and market risks
An operational problem with a business transaction could trigger a credit or market risk
?nder the &asel %% Accord, operational risk is defined as Pthe risk of loss resulting from
inadequate processes, people and systems or from external e!entsQ #he management of
operational risk requires systems capable of identifying, recording and quantifyingoperational failures that may cause financial loss #he systems are essentially tracking
processes that monitor the beha!ior and performance of existing systems and processes
#he essential elements include .) the ability to track and monitor performances ofspecified operational processes and systems, ;) maintenance of databases of operational
loss experience history, and :) capacity to pro!ide exception reporting or initiate actions
to enable inter!ention to reduce operational risks
&ank for %nternational +ettlement (&%+) has proposed that, as of ;881, banks should be
made to carry a 7apital cushion against losses from this risk
Managing operational risk is becoming an important feature of sound risk management
practices in modern financial markets in the wake of phenomenal increase in the !olume
of transactions, high degree of structural changes and complex support systems #he most
important type of operational risk in!ol!es breakdowns in internal controls and corporate
go!ernance +uch breakdowns can lead to financial loss through error, fraud, or failure toperform in a timely manner or cause the interest of the bank to be compromised
#he ob=ecti!es of 'perational isk Management is to reduce the expected operational
losses that focuses on systematic remo!al of operational risk sources and uses a set of key
risk indicators to measure and control risk on continuous basis #he ultimate ob=ecti!e of
operational risk management is to enhance the shareholders !alue by being ready for risk
18
8/13/2019 94778973 Asset and Liability Management in Indian Banks
19/28
based capital allocation #here is no uniformity of approach in measurement of
'perational isk in the banking system at present
M$t#od o) o($rationa& rik ,anag$,$nt
&asel %% and !arious +uper!isory bodies of the countries ha!e prescribed !arious
soundness standards for 'perational isk Management for &anks and similar 4inancial%nstitutions #o complement these standards, &asel %% has gi!en guidance to : broad
methods of 7apital calculation for 'perational isk
Baic indicator a((roac# - based on annual re!enue of the 4inancial %nstitution
Standardi'$da((roac#: - based on annual re!enue of each of the broad business linesof the 4inancial %nstitution
Ad!anced measurement approach - based on the internally de!eloped risk measurement
framework of the bank adhering to the standards prescribed (methods include %MA, L>A,
+cenario-based, +corecard etc)
#he 'perational isk Management framework should include identification,measurement, and monitoring, reporting, control and mitigation frameworks for
'perational isk
-BI Guid$&in$ on ALM:
As per &% guidelines, commercial banks are to distribute the outflows"inflows in
different residual maturity period known as #ime buckets #he Assets and Liabilities
were earlier di!ided into 0 maturity buckets (.-.9 daysG .
8/13/2019 94778973 Asset and Liability Management in Indian Banks
20/28
After such an exercise, each bucket of assets is matched with the corresponding
bucket of the liability Dhen in a particular maturity bucket, the amount of
maturing liabilities or assets does not match, such position is called a mismatch
position, which creates liquidity surplus or liquidity crunch position and
depending upon the interest rate mo!ement, such situation may turn out to be
risky for the bank &anks are required to monitor such mismatches and take
appropriate steps so that bank is not exposed to risks due to the interest
rate mo!ements during that period
(b) #he net cumulati!e negati!e mismatches during the 3ext day, ;-/ days, 0-.9 days
and .
8/13/2019 94778973 Asset and Liability Management in Indian Banks
21/28
: An increasing proportion of in!estments by banks is being recorded on a market-to-
market basis and as such large portion of the in!estment portfolio s exposed to market
risks 7ountering the ad!erse impact of these changes is possible only through efficient
asset-liability management techniques
9 As the focus on the net interest margin has increased o!er the years, there is anincreasing possibility that the risk arising out of exposure to interest rate !olatility will be
built into the capital adequacy norms specified by the regulatory authorities #his, in turn,
will require efficient asset-liability management practices
In)or,ation t$c#no&og! and a$t%&iabi&it! ,anag$,$nt in t#$ Indian cont$/t
Many of the new pri!ate sector banks and some of the non-banking financial companiesha!e gone in for complete computeri$ation of their branch network and ha!e also
integrated their treasury, forex, and lending segments #he information technology
initiati!es of these institutions pro!ide significant ad!antage to them in asset-liability
management since it facilitates faster flow of information, whichis accurate and reliable %t also helps in terms of quicker decision-making from the central
office since branches are networked and accounts are considered as belonging to the bank
rather than a branch
%n other words, the boundaries of asset-liability management architecture itself is
changing because of substantial changes brought about by information technology, and tothat extent the operations managers are pro!ided with multiple possibilities which were
not earlier a!ailable in the context of large numbers of branch networks and associated
problems of information collection, storage, and retrie!al
%n the %ndian context, asset-liability management refers to the management of deposits,credit, in!estments, borrowing, forex reser!es and capital, keeping in mind the capital
adequacy norms laid down by the regulatory authorities %nformation technology canfacilitate decisions on the following issues
. stimating the main sources of funds like core deposits, certificates of deposits, and call
borrowings . educing the gap between rate sensiti!e assets and rate sensiti!e liabilities, gi!es a
certain le!el of risk
. educing the maturity mismatches so as to a!oid liquidity problems
. Managing funds with respect to crucial factors like si$e and duration
LITE-ATU-E -E5IE6
#here is a considerable literature addressing asset-liability management in banks 'ne of
the key moti!ators of asset-liability management worldwide was the &asel 7ommittee
#he &asel 7ommittee on &anking +uper!ision (;88.) formulated broad super!isorystandards and guidelines and recommended statements of best practice in banking
super!ision #he purpose of the committee was to encourage global con!ergence toward
common approaches and standards %n particular, the &asel %% norms (;889) were
21
8/13/2019 94778973 Asset and Liability Management in Indian Banks
22/28
proposed as an international standard for the amount of capital that banks need to set
aside to guard against the types financial and operational risks they face &asel %%
proposed setting up rigorous risk and capital management requirements designed toensure that a bank holds capital reser!es appropriate to the risk the bank exposes itself to
through its lending and in!estment practices 6enerally speaking, these rules mean that
the greater risk to which the bank is exposed, the greater the amount of capital the bankneeds to hold to safeguard its sol!ency and o!erall economic stability #his would
ultimately help protect the international financial system from the types of problems that
might arise should a ma=or bank or a series of banks collapse
6ardner and Mills (.22.) discussed the principles of asset-liability management as a part
of banks strategic planning and as a response to the changing en!ironment in prudential
super!ision, e-commerce and new taxation treaties #heir text pro!ided the foundation ofsubsequent discussion on asset-liability management
6iokas and Bassiloglou (.22.) de!eloped a goal-programming model for bank asset and
liability management #hey supported the idea that apart from attempting to maximi$ee!enues, management tries to minimi$e risks in!ol!ed in the allocation of the banks
capital, as well as to fulfill other goals of the bank, such as retaining its market share,increasing the si$e of its deposits and loans
Faslem et al (.222) used canonical analysis and the interpreti!e framework ofasset"liability management in order to identify and interpret the foreign and domestic
balance sheet strategies of large ?+ banks in the context of the Pcrisis in lending to
L>7sQ #heir study found that the least profitable !ery large banks ha!e the largest
proportions of foreign loans, yet they emphasi$e domestic balance sheet (asset"liability)matching strategies 7on!ersely, the most profitable !ery large banks ha!e the smallest
proportions of foreign loans, but, nonetheless, they emphasi$e foreign balance sheet
matching strategies
Baidyanathan (.222) found that se!eral banks had inadequate and inefficient
Management systems and also he argued that %ndian banks were more exposed to%nternational markets, especially with respect to 4'R transactions, so that Asset
Liability Management was essential, as it would enable the bank to maintain its exposure
to foreign currency fluctuations gi!en the le!el of risk it can handle Fe also found that
an increasing proportion of in!estments by banks were being recorded on a marked-tomarket basis, thus being exposed to market risks Fe also suggested that, as bank
profitability focus has increased o!er the years, there is an increasing possibility that the
risk arising out of exposure to interest rate !olatility would be built into the capitaladequacy norms specified by the regulatory authorities, thus in turn requiring efficient
asset-liability management practices
Baidya and +hahi (;88.) studied asset-liability management in %ndian banks #hey
suggested in particular that interest rate risk and liquidity risk are two key inputs in
business planning process of banks
22
8/13/2019 94778973 Asset and Liability Management in Indian Banks
23/28
an=an and 3allari (;889) used canonical analysis to examine asset-liability management
in %ndian banks in the period .22;-;889 #hey found that +&% and associates had the best
asset-liability management in the period .22;-;889 #hey also found that, other thanforeign banks, all other banks could be said to be liability managedG ie they all borrowed
from the money market to meet their maturing obligations *ri!ate &anks were found to
be aggressi!e in profit generation, while nationali$ed banks were found to be excessi!elyconcerned about liquidity
#here ha!e been se!eral applications of mathematical models in the field of bankmanagement #he deterministic linear programming model of 7hambers and 7harnes
(.21.) was the first of its kind in ALM 7ohen and Fammer (.21/), obertson (.2/;)
ha!e reali$ed successful applications of 7hambers and 7harnes model !en though
these models ha!e differed in their treatment of disaggregation, uncertainty and dynamicconsiderations, they all ha!e in common the fact that they are specified to optimi$e a
single ob=ecti!e profit function sub=ect to the rele!ant linear constraints
Apart from the deterministic models, se!eral stochastic models ha!e been proposed sincethe .2/8s #hese models, including the use of chance-constrained programming (7harnes
and #hore, .211G 7harnes and Littlechild, .210G *ogue and &ussard, .2/;), dynamicprogramming (+amuelson, .212G Merton, .212,.228G ppen and 4ama, .2/.), sequential
decision theory (Dolf, .212G &radley and 7rane, .2/;) and stochastic linear
programming under uncertainty (7ohen and #hore, .2/8G &ooth, .2/;G 7rane, .2/.GSallberg et al .20;), presented computational difficulties
An alternati!e approach in considering stochastic models is the stochastic linear
programming with simple recourse Susy and Tiemba (.201) employed a multi-periodstochastic linear program with simple recourse to model the management of assets and
liabilities in banking while maintaining computational feasibility #heir results indicate
that the proposed ALM model is theoretically and operationally superior to acorresponding deterministic linear programming model and that the computational effort
required for its implementation is comparable to that of the deterministic model Another
application of the multistage stochastic programming is the ussell-Iasuda Sasai model(7arino et al, .229), which aims at maximi$ing the long term wealth of the firm while
producing high income returns
Mihir >ash, a!i *athak (;880) studied asset-liability management in %ndian banks using alinear programming model de!eloped according to the asset-liability guidelines pro!ided bythe eser!e &ank of %ndia #he study co!ers all scheduled commercial banks except regional
rural banks (&s), for the year ;88/-80 #he banks are grouped on the basis of ownershipstructure public sector banks (including +&% 5 associates), pri!ate sector banks, and
foreign banks #he general recommendations of the study are that banks must carefully
maintain and monitor their asset-liability positions, balancing profitability, liquidity, and
interest rate risk &anks which were found to satisfy all the liquidity constraints can focus onprofit maximi$ationG on the other hand, banks which were found not to satisfy all the liquidity
constraints should identify which particular constraints they fail, and should subsequentlypursue strategies to satisfy these constraints Also, banks such as F+&7 &ank and +tandard
7hartered &ank, which were found to satisfy all liquidity constraints, but at the cost of
23
8/13/2019 94778973 Asset and Liability Management in Indian Banks
24/28
profitability, should pursue the strategy of profit maximi$ation, ensuring that they satisfy allthe guidelines of &% 4inally, banks which are exposed to interest rate risk should focus on
impro!ing the duration of rate sensiti!e assets"liabilities, as far as possible
+ayonton oy (;8.8) concluded that today ALM departments are addressing (non-trading)foreign exchange risks as well as other risks Also, ALM has extended to non-financial
firms 7orporations ha!e adopted techniques of ALM to address interest-rate exposures,
liquidity risk and foreign exchange risk #hey are using related techniques to address
commodities risks 4or example, airlinesE hedging of fuel prices or manufacturersEhedging of steel prices are often presented as ALM #hus it can be safely said that Asset
Liability Management will continue to grow in future and an efficient ALM technique
will go a long way in managing !olume, mix, maturity, rate sensiti!ity, quality andliquidity of the assets and liabilities so as to earn a sufficient and acceptable return on
the portfolio
N$$d )or t#$ Stud!:
%ndian banks need to be !igilant in the years to come for market opportunities particularly
with the competition en!isaged in the banking sector %n ;888 the beyond, the key
element is that banks should stri!e to achie!e significant increase in their assets forcreating a !ibrant and competiti!e financial system %n the context of global competition,
it is an important task for the %ndian banks to adopt effecti!e ALM techniques to manage
the !olume, mix, maturity, rate sensiti!ity, quality and liquidity of assets and liability as awhole so as to attain a predetermined acceptable risk"reward ration 6lobali$ation has
mandated the %ndian &anks to be efficient in Asset and Liability Management along with
the associated risk management #here is need to insulate the ALM from the risks
associated with the global financial scenario in order to sur!i!e and grow in the intensecompetiti!e conditions An impro!ement in the ALM will result in higher profitability
and resilience in the %ndian &anks #he earlier research studies indicate the critical nature
of ALM *rocess in order to bring in stability in the %ndian 4inancial +ector in general and%ndian &anking +ector in particular Seeping this in !iew, the present research study is
proposed to be undertaken
4or the study, Asset and Liability Management %ndian &anks in general and in &anks of
the +tate &ank of %ndia (+&%), Andhra &ank, %ng Bysya &ank, and %ndustrial 7redit
%n!estment 7orporation of %ndia (%7%7%) bank in particular are chosen representing twonationali$ed banks (+&%, Andhra &ank) and two *ri!ate +ector &anks (%ng Bysya &ank,
%7%7%) proposed for the study
+tate &ank of %ndia (+&%) is the nationEs largest and oldest bank and Andhra &ank was
nationali$ed in the year .208 and ranked as best midsi$ed bank in sur!ey of %ndias best
bank for the year ;8.8
%ng Bysya &ank oldest pri!ate sector bank in %ndia and %7%7% bank is %ndiaEs second bank
(after +tate &ank of %ndia) and its largest pri!ate bank
24
8/13/2019 94778973 Asset and Liability Management in Indian Banks
25/28
8/13/2019 94778973 Asset and Liability Management in Indian Banks
26/28
proper liquidity, interest rate, market risk management and funding, capital and profit
planning and adopting suitable techniques and strategies #he data collected mayG be
edited, classified and tabulated by using multi !ariant tables will be used where!ernecessary to lend the data more precision and systemati$ation #he statistical tools like
A!erages, *ercentages, and A3'BA will be used to analy$e data
Sco($ o) t#$ tud!:%
#he scope of the study is confirmed to the selected branches of the select banks
Sc#$,$ o) C#a($riation:
C#a(t$r I: Introduction-- this chapter is intended to deal with the conceptual analysisof Asset and Liability management in banks, ALM process, the international norms
&A+L % and &A+L %%, the &% policy, &ench marking, isk exposure, Literature
sur!ey, need for the study, methodology etc
C#a(t$r II: Banking Indutr! in India 7 Tr$nd and "$r)or,anc$ 7 #his chapter is
to deal with the brief introduction of %ndian banking industry, the phases of financialsector reforms, recommendations of the 3arasimham committee, current scenario of the
banking industry in %ndia
C#a(t$r II: Li1uidit! and Fund Manag$,$ntUthis chapter includes meaning,
dimensions, causes, symptoms, factors of liquidity risk, liquidity measurement
approaches, &% guidelines on liquidity risk and contingency plan for liquidity
management and fund management
C#a(t$r III: Int$r$t -at$ -ik Manag$,$nt C this chapter includes measuring
interest rate risk, 6A* analysis, preparation of 6A* report, 6A* analysis prudential
norms, altering 6A*, duration 6A* analysis and simulation
C#a(t$r I5: Manag$,$nt o) Mark$t -ikC this chapter explains trade and foreignexchange risk, #ransaction exposure, #echniques of foreign exchange risk, 4utures and
4orward contracts, >eri!ati!es, 'ptions and +waps
C#a(t$r 5: O($rationa& -ik ,anag$,$nt 7 this chapter explains meaning ofoperational risk, ob=ecti!es and method operational risk management
C#a(t$r 5I: Conc&uion and Sugg$tion-- #his chapter is to conclude the topic bygi!ing suggestions #he ALM would help the banks to boost up their profits, smooth
recycling of funds in the nation #his would help the nation to de!elop more banking
branches and de!eloping the economy by pro!iding the better financial ser!ices to thenation
eferences
. Alexander Adam, P#he Fand &ook of Asset and Liability Management- from
models to optimal return strategiesQ, the Diley 5 +ons financial series
; Moorad 7howdary, P&ank Asset and Liability Management strategy, tradingand analysisQ, the Diley 5 +ons financial series
26
8/13/2019 94778973 Asset and Liability Management in Indian Banks
27/28
: >r & 7harumathi, PAsset Liability Management in %ndian &anking %ndustry -
with special reference to %nterest ate isk Management in %7%7% &ankQ,
*roceedings of the Dorld 7ongress on ngineering ;880 Bol %% , D7 ;880,@uly ; - 9, ;880, London, ?S
9 PAsset Liability Management in &anksQ, a presentation by Siran +harma
member of 4aculty 7A&, &%, *?3
8/13/2019 94778973 Asset and Liability Management in Indian Banks
28/28
;8 ;8 7howdarip,Q Asset Liability Management in &ankingQ, A!ailable at
wwwauthorstreamcom"presentaion"chowdarip-./0/.8
;. ;. *eter ose, +yl!ia Fudgins, P&ank Management 5 4inancial +er!icesQ,
7hapter /, Asset and Liability Management >etermining and measuring
%nterest ates and 7ontrolling %nterest +ensiti!e and >uration 6A*s
;; ;; Bikram +ingh +ankhala,Q Asset Liability ManagementQ, on 3o!ember 2 th
;8.8, A!ailable at wwwslidesharenet"!ikramsankhala"asset-liability-management-