CHAPTER-1:INTRODUCTION

1.1 Introduction

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Assets and Liabilities Management (ALM) is a dynamic process of planning, organizing,

coordinating and controlling the assets and liabilities – their mixes, volumes, maturities, yields and

costs in order to achieve a specified Net Interest Income (NII). The NII is the difference between

interest income and interest expenses and the basic source of banks profitability. The easing of

controls on interest rates has led to higher interest rate volatility in India. Hence, there is a need to

measure and monitor the interest rate exposure of Indian banks.

Banks are always aiming at maximizing profitability at the same time trying to ensure

sufficient liquidity to repose confidence in the minds of the depositors on their ability in servicing

the deposits by making timely payment of interest/returning them on due dates and meeting all

other liability commitments as agreed upon. To achieve these objectives, it is essential that banks

have to monitor, maintain and manage their assets and liabilities portfolios in a systematic manner

taking into account the various risks involved in these areas. This concept has gained importance in

Indian conditions in the wake of the ongoing financial sector reforms, particularly reforms relating

to interest rate deregulation. The technique of managing both assets and liabilities together has

come into being as a strategic response of banks to inflationary pressure, volatility in interest rates

and severe recessionary trends which marked the global economy in the seventies and eighties.

The commercial banking sector plays an important role in mobilization of deposits and

disbursement of credit to various sectors of the economy. A sound and efficient banking system is

essential for maintaining financial stability. The financial strength of individual banks, which are

major participants in the financial system, is the first line of defence against financial risks. The

banking industry in India is undergoing transformation since the beginning of liberalization. Banks

in India are venturing into non-traditional areas and generating income through diversified activities

other than the core banking activities. There have been new banks, new instruments, new windows,

new opportunities and, along with all this, new challenges. While deregulation has opened up new

vistas for banks to augment revenues, it has entailed greater competition, reduced margins and

consequently greater risks. Banks enter into off balance sheet (OBS) transactions for extending

non-fund based facilities to their clients, balance sheet risk management and generating profits

through leveraged positions. OBS exposures of banks, especially public sector banks have

witnessed a phenomenal spurt in recent years.

The start of the reforms in Banking Sector brought out number of skeletons and exposed the

darker side of the banking industry. Some of these were:-

(a) Mind blowing size of the Non Performing Assets;

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(b) Losses in number of banks

(c) Overstaffing in most of the public sector banks

(d) Scant respect for norms for income recognition and international standard accounting practices.

1.2 Rationale of the Study:-

This is the era of reforms in the Economy. Indian banking sector is facing a lot of

challenges now-a-days regarding management of Assets and Liability. In general the deposits

which are the liability for the banks are for short-term periods and the loans which are assets for the

banks are for the long-term periods. So it is very difficult for the banks to arrange the funds to meet

the demand for both the sides. In the other hand deposits are mainly for on-demand payments. So

the assets & Liabilities need to be managed very properly in order to align the short-term & Long-

term funds accordingly. The interest rates also fluctuate to attract deposits and as a result it also

results in a higher lending rate which creates a less demand for loans. It is observed that the NPA

level of banks is getting increased day by day which is also caused by Asset-Liability mismatch up

to some extent. Sometimes banks are failing in timely payment to customers who opt for heavy

amount withdraws. The banks are facing a lot of challenges due to heavy risks they are taking.

Though a lots of studies have been conducted on this topic, yet the banks suffering from this

problem. Still there is a scope for improvement in the management of asset and liabilities of the

banks. That’s why the subject has been taken into consideration so that some new findings can be

suggested which will help the bankers.1.3 Review of Literature:-

1.4Objectives:-

To study the concept of Asset & Liability Management

To study the various risk measures undertaken through ALM.

To analyse the Interest Rate Risk Management system in SBI Bank.

1.5 Research Methodology:-

Methodology is the back bone of the project work. It involves the ways and means by which the

researcher selects his sample, sample size, Methods of data collection.

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Scope of the Study:

The scope of my study pertains to all the data, resources, information and knowledge collected

from the websites of SBI,RBI & other websites, Direct interaction with the experienced people etc.

Although the scope is not so vast, still it contains as many information as was possible on my part

to collect within the limited time-frame.

Sources of Data:

The study is mainly based on secondary data. The secondary data were collected from the

annual reports of SBI Bank, circulars of the SBI Bank, reading material on ALM, RBI Reports,

websites and various journals.

Time Frame:

3 years data has been taken into consideration.

Tools & Techniques used:

Statistical tools like Addition, Average etc are used to analyse the data. Gap Analysis

Technique (prescribed by RBI) has been used for measuring the interest rate risk.

This is an analytical research study. It selected SBI Bank, one of the largest public sector

banks in India. The bank is listed in BSE Sensex and NSE Nifty.

1.7 Limitations:-

This subject is based on past data of State Bank of India.

The study is mainly based on secondary data.

Some results are approximated, as no accurate data is Available.

Time was a limiting factor in this study

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The area of study considered was quite a vast field of study and lack of sufficient

time was also a constraint.

Due to lack of time and some other reasons, the primary data couldn’t be

collected which could give a better result of the study.

1.6 Study Design:-

Chapter-1: Introduction

Chapter-2: Bank Profile

Chapter-3: Overall ALM

Chapter-4: Case Study

Chapter-5: Findings, Suggestions and Conclusion

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CHAPTER-2:BANK PROFILE

2.1 State Bank of India: An overview:-

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State Bank of India (SBI) is a multinational banking and financial services company based in India.

It is a government-owned corporation with its headquarters in Mumbai, Maharashtra. As of

December 2013, it had assets of US$388 billion and 17,000 branches, including 190 foreign

offices, making it the largest banking and financial services company in India by assets.

State Bank of India is one of the Big Four banks of India, along with ICICI Bank, Punjab National

Bank and Bank of Baroda.

The bank traces its ancestry to British India, through the Imperial Bank of India, to the founding in

1806 of the Bank of Calcutta, making it the oldest commercial bank in the Indian Subcontinent.

Bank of Madras merged into the other two presidency banks—Bank of Calcutta and Bank of

Bombay—to form the Imperial Bank of India, which in turn became the State Bank of India.

Government of India owned the Imperial Bank of India in 1955, with Reserve Bank of India taking

a 60% stake, and renamed it the State Bank of India. In 2008, the government took over the stake

held by the Reserve Bank of India.

SBI is a regional banking behemoth and has 20% market share in deposits and loans among Indian

commercial banks.

SBI provides a range of banking products through its network of branches in India and overseas,

including products aimed at non-resident Indians (NRIs). SBI has 14 regional hubs and 57 Zonal

Offices that are located at important cities throughout India.

2.2 Domestic presence:-

SBI had 14,816 branches in India, as on 31 March 2013, of which 9,851 (66%) were in Rural and

Semi-urban areas. In the financial year 2012-13, its revenue was INR 200,560 Crores (US$ 36.9

billion), out of which domestic operations contributed to 95.35% of revenue. Similarly, domestic

operations contributed to 88.37% of total profits for the same financial year.

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2.3 International presence:-

The Israeli branch of the State Bank of India located in Ramat Gan.

As of 28 June 2013, the bank had 180 overseas offices spread over 34 countries. It has branches of

the parent in Moscow, Colombo, Dhaka, Frankfurt, Hong Kong, Tehran, Johannesburg, London,

Los Angeles, Male in the Maldives, Muscat, Dubai, New York, Osaka, Sydney, and Tokyo. It has

offshore banking units in the Bahamas, Bahrain, and Singapore, and representative offices in

Bhutan and Cape Town. It also has an ADB in Boston, USA.

The Canadian subsidiary, State Bank of India (Canada) also dates to 1982. It has seven branches,

four in the Toronto area and three in the Vancouver area.

SBI operates several foreign subsidiaries or affiliates. In 1990, it established an offshore bank: State

Bank of India (Mauritius). SBI (Mauritius) has 15 branches in major cities/towns of the country

including Rodrigues.

State Bank of India (S.B.I.) has Branch at Tsim Sha Tsui, Hong Kong

In 1982, the bank established a subsidiary, State Bank of India (California), which now has ten

branches – nine branches in the state of California and one in Washington, D.C. The 10th branch

was opened in Fremont, California on 28 March 2011. The other eight branches in California are

located in Los Angeles, Artesia, San Jose, Canoga Park, Fresno, San Diego, Tustin and Bakersfield.

In Nigeria, SBI operates as INMB Bank. This bank began in 1981 as the Indo-Nigerian Merchant

Bank and received permission in 2002 to commence retail banking. It now has five branches in

Nigeria.

In Nepal, SBI owns 55% of Nepal SBI Bank, which has branches throughout the country. In

Moscow, SBI owns 60% of Commercial Bank of India, with Canara Bank owning the rest. In

Indonesia, it owns 76% of PT Bank Indo Monex.

The State Bank of India already has a branch in Shanghai and plans to open one in Tianjin.

In Kenya, State Bank of India owns 76% of Giro Commercial Bank, which it acquired for US$8

million in October 2005.

2.4 Associate banks:-

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SBI main branch at Mumbai lit up

Main Branch of SBI in Mumbai.

SBI has five associate banks; all use the State Bank of India logo, which is a blue circle, and all use

the "State Bank of" name, followed by the regional headquarters' name:

State Bank of Bikaner & Jaipur

State Bank of Hyderabad

State Bank of Mysore

State Bank of Patiala

State Bank of Travancore

2.5 Non-banking subsidiariesApart from its five associate banks, SBI also has the following non-banking subsidiaries:

SBI Capital Markets Ltd

SBI Funds Management Pvt Ltd

SBI Factors & Commercial Services Pvt Ltd

SBI Cards & Payments Services Pvt. Ltd. (SBICPSL)

SBI DFHI Ltd

SBI Life Insurance Company Limited

SBI General Insurance

In March 2001, SBI (with 74% of the total capital), joined with BNP Paribas (with 26% of the

remaining capital), to form a joint venture life insurance company named SBI Life Insurance

company Ltd. In 2004, SBI DFHI (Discount and Finance House of India) was founded with its

headquarters in Mumbai.

2.6 Logo and slogan:-

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The logo of the State Bank of India is a blue circle with a small cut in the bottom that depicts

perfection and the small man the common man - being the centre of the bank's business. The logo

came from National Institute of Design(NID), Ahmedabad and it was inspired by Kankaria Lake,

Ahmedabad.

Slogans: "PURE BANKING, NOTHING ELSE", "WITH YOU - ALL THE WAY", "A BANK

OF THE COMMON MAN", "THE BANKER TO EVERY INDIAN", "THE NATION BANKS

ON US"

2.7 Recent awards and recognitions:- SBI was ranked as the top bank in India based on tier 1 capital by The Banker magazine in a

2014 ranking.

SBI was ranked 298th in the Fortune Global 500 rankings of the world's biggest corporations for

the year 2012.

SBI won "Best Public Sector Bank" award in the D&B India's study on 'India's Top Banks 2013'.

State Bank of India won three IDRBT Banking Technology Excellence Awards 2013 for

“Electronic Payment Systems”, “Best use of technology for Financial Inclusion”, and “Customer

Management & Business Intelligence” in the large bank category.

SBI won National Award for its performance in the implementation of Prime Minister’s

Employment Generation Programme (PMEGP) scheme for the year 2012.

Best Online Banking Award, Best Customer Initiative Award & Best Risk Management Award

(Runner Up) by IBA Banking Technology Awards 2010

SKOCH Award 2010 for Virtual corporation Category for its e-payment solution

SBI was the only bank featured in the "top 10 brands of India" list in an annual survey conducted

by Brand Finance and The Economic Times in 2010.

The Bank of the year 2009, India (won the second year in a row) by The Banker Magazine

Best Bank – Large and Most Socially Responsible Bank by the Business Bank Awards 2009

Best Bank 2009 by Business India

The Most Trusted Brand 2009 by The Economic Times.

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SBI was named the 29th most reputed company in the world according to Forbes 2009 rankings

Most Preferred Bank & Most preferred Home loan provider by CNBC

Visionaries of Financial Inclusion By FINO

Technology Bank of the Year by IBA Banking Technology Awards

SBI was 11th most trusted brand in India as per the Brand Trust Report 2010.

2.8 Major competitors:-Some of the major competitors for SBI in the banking sector are Axis Bank, ICICI Bank, HDFC

Bank, Punjab National Bank, Bank of Baroda, Canara Bank and Bank of India. However in terms

of average market share, SBI is by far the largest player in the market.

2.9 VISION:- My SBI.

My Customer first.

My SBI: First in customer satisfaction

2.10 MISSION:- We will be prompt, polite and proactive with our customers.

We will speak the language of young India.

We will create products and services that help our customers achieve their goals.

We will go beyond the call of duty to make our customers feel valued.

We will be of service even in the remotest part of our country.

We will offer excellence in services to those abroad as much as we do to those in

India.

We will imbibe state of the art technology to drive excellence.

2.11 VALUES:-

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We will always be honest, transparent and ethical.

We will respect our customers and fellow associates.

We will be knowledge driven.

We will learn and we will share our learning.

We will never take the easy way out.

We will do everything we can to contribute to the community we work in.

We will nurture pride in India

2.12 Management Team:-

Sr.No. Name Designation Under Section of SBI

Act 1955

1 Smt. Arundhati Bhattacharya Chairman 19(a)

2 Shri Hemant G. Contractor Managing Director 19 (b)

3 Shri A. Krishna Kumar Managing Director 19 (b)

4 Shri S.Vishvanathan Managing Director 19 (b)

5 Shri P. Pradeep Kumar Managing Director 19(b)

6 Shri S. Venkatachalam Director 19 (c)

7 Shri D. Sundaram Director 19 (c)

8 Shri Parthasarathy Iyengar Director 19 (c)

9 Shri Thomas Mathew Director 19 (c)

10 Shri Jyoti Bhushan Mohapatra Workmen Employee

Director

19 (ca)

11 Shri S.K. Mukherjee Officer Employee Director 19 (cb)

12 Dr. Rajiv Kumar Director 19 (d)

13 Shri Deepak I. Amin Director 19 (d)

14 Shri Harichandra Bahadur Singh Director 19 (d)

15 Shri Tribhuwan Nath Chaturvedi Director 19(d)

16 Shri Gurdial Singh Sandhu Director 19 (e)

17 Dr. Urjit R. Patel Director 19 (f)

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CHAPTER-3:OVERALL ALM

3.1 CONCEPT OF ALM:-

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ALM is the practice of managing a business so that decisions and actions taken with respect

to assets and liabilities are coordinated. ALM can be defined as the ongoing process of formulating,

implementing, monitoring and revising strategies related to assets and liabilities to achieve an

organization's financial objectives, given the organization's risk tolerances and other constraints.

ALM is relevant to, and critical for, the sound management of the finances of any organization that

invests to meet its future cash flow needs and capital requirements.

3.2 PURPOSE OF ALM:-

Capture the maturity structure of the cash flows (inflows and outflows) in the Statement of

Structural Liquidity

Tolerance levels for various maturities may be fixed by the bank keeping in view bank’s ALM

profile, extent of stable deposit base, nature of cash flows etc.

3.3 SIGNIFICANCE OF ALM:-

Volatility

Product Innovations & Complexities

Regulatory Environment

Management Recognition

3.4 WHAT DO YOU MEAN BY ALM??:-

Active management of a bank's Balance Sheet to maintain a mix of loans and deposits

consistent with its goals for long-term growth and risk management. Banks, in the normal course of

business, assume financial risk by making loans at interest rates that differ from rates paid on

deposits. Deposits often have shorter maturities than loans and adjust to current market rates faster

than loans. The result is a balance sheet mismatch between assets (loans) and liabilities (deposits).

The function of asset-liability management is to measure and control three levels of financial risk:

Interest Rate Risk (the pricing difference between loans and deposits), Credit Risk (the probability

of default), and Liquidity Risk (occurring when loans and deposits have different maturities).

A primary objective in asset-liability management is managing Net Interest Margin that is, the net

difference between interest earning assets (loans) and interest paying liabilities (deposits) to

produce consistent growth in the loan portfolio and shareholder earnings, regardless of short-term

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movement in interest rates. The dollar difference between assets (loans) maturing or re-pricing and

liabilities (deposits) is known as the rate sensitivity Gap (or maturity gap). Banks attempt to

manage this asset-liability gap by pricing some of their loans at variable interest rates.

A more precise measure of interest rate risk is Duration which measures the impact of changes in

interest rates on the expected maturities of both assets and liabilities. In essence, duration takes the

gap report data and converts that information into present-value worth of deposits and loans, which

is more meaningful in estimating maturities and the probability that either assets or liabilities will

re-price during the period under review. Besides financial institutions, nonfinancial companies also

employ asset-liability management, mainly through the use of derivative contracts to minimize their

exposures on the liability side of the balance sheet.

3.5 TECHNIQUES OF ALM:-

Asset Liability management is a very broad field targeting risk management, which includes

assessment of various types of risk the current assets and the forthcoming liabilities are exposed to.

This is of major importance to the banking and financial service industry. There are a number of

risk management consulting firms that research and work in this field. They provide various

optimization tools and software and risk assessment models, which assist in the asset-liability

management process.

There are various asset optimization and portfolio management models that can help and form a

part of the asset liability management technique. In general an ALM technique involves defining of

risk and return relative to liability portfolio. The key to asset liability management lies in the ability

to design an asset portfolio that depends on the risk to which the investor is exposed i.e. to devise a

portfolio perfectly correlated with the future liabilities of the investor.

3.6 DIFFERENCE BETWEEN ASSET MANAGMENT & LIABILITY MANAGEMENT:-

Asset management involves the management of assets, such as investments or property.

Liability management is the flip side of the coin: the management of debts, loans and mortgages for

example. Most people and indeed most companies have a mixture of assets and liabilities to

manage in order to maximise their returns or their growth of wealth. If liabilities are ill-attended,

they can result in forced sell-offs of assets and where liabilities are far greater than the assets of

course, individuals can be considered to be very highly leveraged.

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3.7 OBJECTIVE OF ALM:-

The objective of asset and liability management is to develop and implement policies and processes

to assist in:

identifying, acquiring, accurately valuing, managing and disposing of assets, and ensuring

those assets are put to optimal use for purposes consistent with site objectives

identifying, incurring, accurately valuing, and meeting liabilities and ensuring those liabilities

are only incurred for purposes consistent with agency objectives.

3.8 Categories of risk:-

Risk in a way can be defined as the chance or the probability of loss or damage.

In the case of banks, these include credit risk, capital risk, market risk, interest rate risk, and

liquidity risk. These categories of financial risk require focus, since financial institutions like banks

do have complexities and rapid changes in their operating environments.

Although there are many risks involved with the business of the banks, yet Interest Rate

Risk is a major case and has many impacts on the bank’s business.

Interest rate risk:

Interest risk is the change in prices of bonds that could occur as a result of change: in interest rates.

It also considers change in impact on interest income due to

changes in the rate of interest. In other words, price as well as reinvestment risks require focus. In

so far as the terms for which interest rates were fixed on deposits differed from those for which

they fixed on assets, banks incurred interest rate risk i.e., they stood to make gains or losses with

every change in the level of interest rates.

The banking industry in India has substantially more issues associated with interest rate

risk, which is due to circumstances outside its control. This poses extra challenges to the banking

sector and to that extent; they have to adopt innovative and sophisticated techniques to meet some

of these challenges. There are certain measures available to measure interest rate risk. These

include:

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Maturity: Since it takes into account only the timing of the final principal payment,

maturity is considered as an approximate measure of risk and in a sense does not quantify risk.

Longer maturity bonds are generally subject to more interest rate risk than shorter maturity bonds.

Duration: Is the weighted average time of all cash flows, with weights being

the present values of cash flows. Duration can again be used to determine the sensitivity of

prices to changes in interest rates. It represents the percentage change in value in response to

changes in interest rates.

Dollar duration: Represents the actual dollar change in the market value of a holding of the

bond in response to a percentage change in rates.

Convexity: Because of a change in market rates and because of passage of time, duration

may not remain constant. With each successive basis point movement downward, bond prices

increase at an increasing rate. Similarly if rates increase, the rate of decline of bond prices declines.

This property is called convexity.

In the Indian context, banks in the past were primarily concerned about adhering to statutory

liquidity ratio norms and to that extent they were acquiring government securities and holding it till

maturity. But in the changed situation, namely moving away from administered interest rate

structure to market determined rates, it becomes important for banks to equip themselves with some

of these techniques, in order to immunize banks against interest rate risk

Interest Rate risk is the exposure of a bank’s 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 bank’s earnings and capital base

Changes in interest rates also affect the underlying value of the bank’s 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

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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 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 for closure of loans that earned a good spread.

3.9 ALM Core Functions - Managing Interest Rate Risk, Structural Gaps and Liquidity:-

The ALM core function consists of managing maturity gaps and mismatches while

managing interest rate risk within the overall mandate prescribed by ALCO. The key

responsibilities and some typical actions initiated by the ALM team are dealt with in the following

paragraphs:

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INTEREST RATE RISK

BASIS

RE-PRICINGYIELD

OPTIONS

1. Managing Structural Gaps

In a financial institution with a mature ALM function, this is arguably the most critically

and continuously monitored aspect, since the ALM Managers seek to manage the structural gaps in

the Balance Sheet. While liquidity management focuses typically on short-term time ladders, the

structural gap management shifts

the focus on time ladders more than a year. This aspect of ALM stresses the importance of

balancing maturities as well as cash flows on either side of balance sheet. It strategizes dynamically

on balancing the gaps, issuing timely guidelines to adjust focus on ‘right’ product types and tenors,

and actively involve ALCO in this process.

a. Static Gap: The ALM function takes into consideration assets maturing in short,

medium and long time ladders and seeks to balance it vis-à-vis liabilities maturing across short,

medium and long term ladders. The gaps reports typically point to funding gaps and excess funds at

different points in time. The challenge with the ALM function is that the gaps are dynamically

evolving and need continuous monitoring as the balance sheet changes every day.

b. Duration: Duration is considered as a measure of interest rate sensitivity. However,

for our immediate purpose, let us set aside interest rate sensitivity. Macaulay’s duration is

traditionally accepted as a good measure of ‘length’ of portfolio or a measure of center of gravity of

discounted cash-flows over life of an asset (or liability). It’s common practice to measure duration

of portfolio for different product types as well as on an overall portfolio level. It’s useful to

simulate how duration of portfolio will be affected by future events.

c. Dynamic Gap: It is normal practice to rely on dynamic gap reports to simulate

future gap positions for assumed business volumes and exercise of options (e.g., prepayments). In

addition to proposed new volumes, prepayment transactions and assumed deposit roll-overs, the

ALM manager would like to include a proposed hedge transaction.

d. Long-Term Assets / Long-Term Liabilities Ratio: ALM practitioners prefer to

focus on the ratio of assets and liabilities exceeding one year and often want to set acceptable limits

around this. Where there are operative limits, the ALCO meetings will usually monitor the ratio,

and the institution constantly endeavors to stay within a comfortable level around this limit. This

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along with liquidity gaps help to bring in any imbalances and help maintain a structurally sound

balance sheet.

2. Managing Interest Rate Sensitivity

A financial institution typically relies on certain measures to evaluate and manage interest

rate sensitivities. We deal with them below:

a. Interest Rate Sensitivity Gap Reports: The ALM function seeks to monitor

interest rate sensitivity by generating so-called interest rate sensitive gap reports, which provide a

cash flow laddering based on re-pricing profile and frequency of interest rate sensitive assets and

liabilities.

b. Duration Measures: Modified duration seeks to measure net present value of a loan

portfolio (simply bond price) under different interest rate conditions. For example, one seeks to

analyze by how much percentage the bond price will be affected by a basis point up and down

move in interest rates. The resulting outputs help us determine the modified duration or simply

interest rate sensitivity of the net present value or bond price.

c. DV01 or PVBP: This one is arguably the most popular measure among ALM

practitioners. DV01 seeks to calculate the dollar value by which the market value is affected by a

basis point expected movement in the interest rates. It’s common to find leading banks setting

internal limits around this measure to manage interest rate risk in the balance sheet.

d. Net Interest Income (NII) Sensitivity: Financial institutions attach much importance to

assessing the impact of interest rate changes, new business, change in product-mix and roll-over of

deposits on net interest income. Income statements that allow for comparison of net interest income

under different scenarios are immensely helpful in understanding the impact of mild market

movements and shocks on the income statement as well as balance sheet

3. Managing Liquidity

Typically, the ALM function seeks to generate daily gaps on short-term ladders and ensures

that cumulative gaps operate within pre-set limits. Of course, managing liquidity gaps alone is not

adequate. A well managed liquidity function will include liquidity contingency plan, liquid asset

buffers and setting liquidity policies and limits in tune with level of risk that the management

believes is acceptable and manageable.

4. ALCO Reporting

In most banks, ALCO meets at pre-determined intervals and the agenda is usually pre-

determined. In order that ALCO meetings are effective, the ALCO pack (comprehensive in many

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cases) is distributed in advance and reviewed in the meeting. The reports include some of what is

listed above and certain other reports.

The ALCO function is critical to ALM function and serves as the reviewing and approving

authority for several key decisions including balance sheet structure, gap analysis, capital adequacy

ratios and above all pro-active management of Balance Sheet.

5. Funds Transfer Pricing (FTP)

A healthy FTP mechanism is part of a healthy ALM solution FTP helps to ensure the

demarcation between market risk and credit risk by passing on the appropriate cost of funds to

respective owners of risk. In recent years, focus has been placed on not just the base FTP, but also

on including FTP add-ons like liquidity premium and similar adjustments. Financial institutions

appear to be reviewing their FTP practices including the basis for liquidity premium both as a result

of process improvement and increasing regulatory interest.

3.10 Key Components of ALM Solution:-

1. Cash-flow Engine: A significant aspect of ALM consists of forecasting and

generating future cash flows based on historical data and assumed scenarios. A time tested cash

flow engine that’s capable of modeling a wide range of financial products on and off the Balance

Sheet is a crucial part of an ALM solution.

2. Unified Data Model: Having a pre-defined, financial products-specific and time

tested analytics data model accelerates implementation by providing a head-start. Further it helps

leverage and makes much wider use of data for a wider range of analytics apart from ALM. This is

useful especially considering that enterprise-wide time series data at a granular level is stored in our

analytical applications over time.

3. Market Rates and Economic Scenarios: Define external economic indicators as

well as define interest rate scenarios and forecast rate movements. Maintain economic assumptions

separately to quickly develop alternative forecasts and stress test the Balance Sheet under

alternative environments.

4. Deterministic and Stochastic Analysis: There are broadly two approaches to

making ALM forecasts. In the deterministic approach, the user makes explicit assumptions about

interest rate movements and forecasts interest rates and currency exchange rates for various

scenarios and different term points. In Stochastic scenario, the forecast rates are modeled using

Monte Carlo simulation method and the output is then generated at desired confidence intervals.

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The modeling framework additionally allows for simulating the impact of hedging strategies and in

forecasting what a gap report generated at a future point in time will look like.

5. Behavior Modeling: The contractual behavior alone is not adequate in modeling the

Balance Sheet. It is essential to take into consideration behavioral maturity based on historical

observations in order that cash flow predictions are more reliable and in tune with demonstrated

behavioral trends. This applies to core and non-core parts in current and savings accounts, deposit

roll-over assumptions and prepayment assumptions. It is also possible to develop a model for

behavioral trends using certain additional and optional infrastructure components. This tends to be

a separate and more involved stream of the project.

6. Powerful Analytical Reporting: A comprehensive, pre-built set of reports is

available, including static, dynamic and interest rate sensitive gap reports, market value and

economic value added reports, duration reports, NII reports and stochastic reports, and liquidity risk

reports.

3.11 Asset-liability management strategies for correcting mismatch:-

The strategies that can be employed for correcting the mismatch in terms of D(A) > D(L)

can be either liability or asset driven. Asset driven strategies for correcting the mismatch focus on

shortening the duration of the asset portfolio. The commonly employed asset based financing

strategy is securitization. Typically the

long-term asset portfolios like the lease and hire purchase portfolios are securitized; and the

resulting proceeds are either redeployed in short term assets or utilized for repaying short-term

liabilities.

Liability driven strategies basically focus on lengthening the maturity profiles of liabilities.

Such strategies can include for instance issue of external equity in the form of additional equity

shares or compulsorily convertible preference shares, issue of redeemable preference shares,

subordinated debt instruments, debentures and accessing long term debt like bank borrowings and

term loans. Strategies to be

employed for correcting a mismatch in the form of D(A) < D(L) .

Asset driven strategies focus on lengthening the maturity profile of assets by the

deployment of available lendable resources in long-term assets such as lease and hire purchase.

Liability driven strategies focus on shortening the maturity profile of liabilities, which can include,

liquidating bank borrowings which are primarily in the form of cash credit (and hence amenable for

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immediate liquidation), using the prepayment options (if any embedded in the term loans); and the

call options, if any embedded in bonds issued by the company; and raising short-term borrowings

(e.g.: fixed deposits with a tenor of one year) to repay long-term borrowings.

The Problem Of Mismatch

• Mismatches in maturity

• Mismatches in interest rate

• Maturity mismatch is the basis of profitability

• Risk management does not eliminate mismatch – merely manages them

• Interest Rate Risk à Affects profitability

• Liquidity Risk à May lead to liquidation

• General Strategy

Eliminate Liquidity Risk (not the mismatch)

Manage Interest Rate Risk

Asset Liability Transformation

• Banks are exposed to credit and market risks in view of the asset-liability

transformation

• With liberalisation, banks’ operations have become complex and large , requiring

strategic management.

Asset - Liability Management System in banks - Guidelines

Over the last few years the Indian financial markets have witnessed wide ranging changes at

fast pace. Intense competition for business involving both the assets and liabilities, together with

increasing volatility in the domestic interest rates as well as foreign exchange rates, has brought

pressure on the management of banks to maintain a good balance between profitability and long-

term viability. These pressures call for structured and comprehensive measures and not just action.

The Management of banks has to base their business decisions on a dynamic and integrated risk

management system and process, driven by corporate strategy. Banks are exposed to several major

risks in the course of their business - credit risk, interest rate risk, foreign exchange risk, equity /

commodity price risk, liquidity risk and operational risks.

The initial focus of the ALM function would be to enforce the risk management

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discipline viz. managing business after assessing the risks involved. The objective of good

risk management programmes should be that these programmes will evolve into a strategic tool for

bank management.

3.12 The ALM process rests on three pillars:-ALM information systems

=> Management Information System

=> Information availability, accuracy, adequacy and expediency

ALM organisation

=> Structure and responsibilities

=> Level of top management involvement

ALM process

=> Risk parameters

=> Risk identification

=> Risk measurement

=> Risk management

=> Risk policies and tolerance levels.

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ALM PROCESS

3.13 Revised ALM Policy:-{Broad parameters of the ALM Policy}

The ALM policy of the Bank aims at:

Providing a comprehensive and dynamic framework for identifying, measuring,

monitoring and managing market risks(both under normal and stressed scenarios) that needs to be

closely integrated with the Bank’s business strategy.

Assesment of market and liquidity risks and altering the asset liability profile in a

dynamic way in order to protect NII in short run and Market Value of Equity in the long term.

Setting up organizational framework for risk management and monitoring.

Efficient liquidity risk management to ensure the bank’s ability to meet its liabilities

as they become due and also in crisis scenarios.

Measuring interest rates sensitivity of assets and liabilities to ascertain the impact of

change in interest rate on Bank’s net Interest Income(NII).

Components of a bank balance sheet

LIABILITIES ASSETS

Capital Cash &Balances

Reserve and surplus Bal with Bank& Money at call and

short notices

Deposits Investments

Borrowings Advances

Other Liabilities Fixed Assets

Other Assets

Bank’s profit and loss account

A bank’s 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

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3.14 WHY IS ALM ESSENTIAL FOR BANKS?:-

ALM answers three key questions:

1) How much risk does the bank want to take?

This is determined by the ALCO committee to best describe the risk appetite of the bank.

2) How much risk does the bank have now?

This is determined by employing quantitative tools to measure the risks of the bank’s assets

and liabilities.

3) How do we move from our current risk profile to our target risk profile?

This is determined by assessing the risk-response options available to the bank as part of the

ALM process.

ALM is a unique, total balance sheet approach to managing important risks at the enterprise

level. ALM deals with the management of all market risks that result from a bank’s structural

position. This position is primarily created by the bank’s intermediation between depositors and

borrowers. While ALM is most important for retail and universal banks, a growing trend has seen

ALM introduced to trading or investment banks as well. ALM is different from the management of

market risk in trading operations because ALM positions are regarded as being comparatively

illiquid to the trading portfolio; however, these trading positions could be incorporated into

the total balance sheet view of ALM.

Most banks hold a significant portion of their business in illiquid positions held over a

longer term making an ALM process essential to increased capital efficiency and competitiveness

in the market. By modeling ALM risks, banks are seeking to both minimize risk for a given level of

target return and to know how

much to charge customers to fund the capital consumed by these risks. Another task of

ALM is to determine and minimize the internal interest rates that should be charged between the

bank’s business units when they lend funds to each other. This concept, called Funds Transfer

Pricing (FTP), is the first step toward profitability and performance measurement across product

and business lines; it helps the bank determine the component sources of the overall net interest

margin.

The primary risks associated with an ALM process are interest rate risk and funding

liquidity risk. ALM could also, to a lesser extent, include currency and commodity price risk and it

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typically incorporates other important balance sheet drivers into the process, such as funding and

capital planning, regulatory constraints, taxation and profitability and growth.

To mitigate interest rate risks, a bank can respond with a variety of core business decisions

on balance sheet solutions that involve product mix and pricing of loans, deposits and other

borrowings. Or they may reply that the interest rate risk is due to discretionary business decisions

on-balance sheet investment or funding strategies that involve rate characteristics or the maturity

mix of wholesale funding or investment strategies. A third reply to interest rate risk would be off-

balance sheet items, such as derivatives like interest rate swaps, caps, floors, etc.

Both interest rate risk and funding liquidity risk are due to the differences between the

bank’s assets and liabilities.

3.15 ALM PRACTICES:-

Often banks rely on poorly documented internal IT systems understood by only a select few

within the organization. Many banks in Asia Pacific use outdated Excel spreadsheet systems

comprised of multiple worksheet components. The resulting challenges of system maintenance,

additional risk reporting metrics and process improvement quickly cause operational problems

when (inevitably) employee turnover occurs. Moreover, as central banks issue additional regulatory

requirements and guidance, these systems are poorly designed and staffed to meet the evolving

regulatory landscape in a timely way. In short, the risk management challenges of ALM that exist

in a fluid, dynamic, and constantly evolving market climate are treated with a process that is rigidly

defined and static.

Even worse, a large percentage of banks still perform no regular analysis at all, or they rely

on measurements purely from historical results to approximate a view of the perceived risk

exposures in the balance sheet. The reality at these banks is that output from such a primitive

process is summarily dismissed or ignored during Asset Liability Committee (ALCO) Meetings.

Few banks are willing to base strategic decision-making and risk-response from risk profiles of the

balance sheet that are not complete or relevant. Lacking the ALM process to manage the interest

rate term structure and optimize the risk-return profile, these banks have become warehouses of

risk, collecting interest-rate and liquidity sensitivities resulting from an unmanaged organic risk-

taking process.

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Of those institutions that do run a formal software system, many still operate the original

assumptions for forecasting and planning, and reporting requirements from the initial

implementation. Here he ALM investment is restricted to the execution of the system and not to the

process of managing the ALM model - analyzing critical output, and driving better decision-

making by integrating risk measurement to the risk management response as defined by the risk

policy and appetite of the bank. This leads to a vicious cycle as internal teams fail to develop the

capabilities to change and manage model assumptions and reporting criteria, or perform any

evaluation of model risk or assumptions risk through back-testing and stress testing exercises. ALM

system capabilities inevitably decline as they are not updated, usually due to the bank’s fear of the

unknown.

3.16 MAKING ALM USEFUL TO THE BANK:-Regulatory reporting is important and the ability to capture full reporting requirements in an

effortless way in the ALM system should be an important consideration. Adopting an ALM system

earns goodwill with bank regulators and avoids unnecessary capital charges for not fully covering

interest rate risk exposures. The real value in an ALM system is the expected improvement and

benefit to operating margins, increased efficiency and precision in risk management processes.

ALM is the first step on the important road to developing business line and product profitability

measures on a risk-adjusted basis.

With an ALM system, the bank has the ability to simulate not only stress scenarios, but also

non-parallel shifts, twists and inversions. Many of the tragic stories from financial institutions who

failed to properly employ an ALM system stem from assumptions about market correlations that

simply cannot be relied upon during extreme conditions. A properly devised ALM process will

contain not only regulatory scenarios executed on a periodic basis, but also a series of strategic

scenarios based on current market conditions or evolving bank activity trends that suggest increased

risk mitigation or vulnerability.

A general rule of thumb in ALM modeling is to keep model assumptions as simple,

straightforward and auditable as possible. If a given process of assumptions development and

maintenance produces the opposite result, the ALCO committee should be very keen to get

involved and ask the business team some pointed questions. This approach represents a role change

for ALCO committee members from primary reviewers of ALM policy, analysis and strategy to

active participants who guide the risk management team toward appropriate strategies for

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maximizing the link between model assumptions, review and utility and overall risk management

strategy.

3.17 Strengthening points for ALM:- Short and long-term minimum capital or equity/total assets goal ratios.

The maximum percentage of assets to be held by any one client, in different types of loans and

investments, in fixed rate investments and loans with a maturity greater than one year, and

invested in fixed assets.

The desired diversification of savings and deposits to eliminate potential concentration risk

(having too much in any one type of deposit or with any one client).

Maximum maturities for all types of loans, investments, and deposits.

Establishment of fixed or variable interest rate loans and deposits.

Pricing strategies for loans and savings products that are based on what it actually costs to

offer the products and what the local market will bear.

3.18 SUCCESS OF ALM IN BANKS: PRE –CONDITIONS:-

Awareness for ALM in the Bank staff at all levels–supportive Management & dedicated

Teams.

Method of reporting data from Branches/ other Departments. (Strong MIS).

Computerization-Full computerization, networking.

Insight into the banking operations, economic forecasting, computerization, investment,credit.

Linking up ALM to future Risk Management Strategies.

Asset-Liability Management has evolved as a vital activity of all financial institutions and to

some extent other industries too. It has become the prime focus in the banking industry, with every

bank trying to maximize yield and reduce their risk exposure. The Reserve Bank of India has issued

guidelines to banks operating in the Indian environment to regulate their asset-liability positions in

order to maintain stability of the financial system.

Maturity-gap analysis has a wide range of focus, not only as a situation analysis tool, but

also as a planning tool. Banks need to maintain the maturity gap as low as possible in order to avoid

any liquidity exposure. This would necessarily mean that the outflows in different maturity buckets

need to be funded from the inflows in the same bucket. As per the RBI’s guidelines, banks have to

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maintain a stable liquidity position in the short term duration, including both 1-14 days and 15-28

days time buckets, to ensure the stability and credibility of the banking system of the country.

CHAPTER-4:CASE STUDY

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INTEREST RATE RISK MANAGEMENT IN SBI

BANK

The bank has three dedicated groups, the Global Risk Management Group (GRMG), the

Compliance Group and the Internal Audit Group which are responsible for assessment,

management and mitigation of risk in the bank. In addition, the Credit and Treasury Middle Office

Groups and the Global Operations Group monitor operational adherence to regulations, policies and

internal approvals. These groups are accountable to the Risk and Audit Committees of the Board of

Directors. GRMG is further organised into the Global Credit Risk Management Group and the

Global Market & Operational Risk Management Group.

Interest rate risk is measured through the use of re-pricing gap analysis and duration analysis.

Liquidity risk is measured through gap analysis. Since the bank’s balance sheet consists

predominantly of rupee assets and liabilities, movements in domestic interest rates constitute the

main source of interest rate risk. Exposure to fluctuations in interest rates is measured primarily by

way of gap analysis, providing a static view of the maturity and re-pricing characteristics of balance

sheet positions. An interest rate gap report is prepared by classifying all assets and liabilities into

various time period categories according to contracted maturities or anticipated re-pricing date. The

difference in the amount of assets and liabilities maturing or being re-priced in any time period

category, would then give an indication of the extent of exposure to the risk of potential changes in

the margins on new or re-priced assets and liabilities. SBI Bank prepares interest rate risk reports

on a fortnightly basis. These reports are submitted to the Reserve Bank of India on a monthly basis.

Interest rate risk is further monitored through interest rate risk limits approved by the Asset

Liability Management Committee.

The bank’s core business is deposit taking and lending and these activities expose it to interest rate

risk. The bank’s primary source of funding is deposits and, to a smaller extent, borrowings.

GAP ANALYSIS TECHNIQUEGap analysis is a technique of asset-liability management that can be used to assess interest rate risk

or liquidity risk. It measures at a given date the gaps between rate sensitive liabilities (RSL) and

rate sensitive assets (RSA) (including off-balance sheet positions) by grouping them into time

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buckets according to residual maturity or next repricing period, whichever is earlier. An asset or

liability is treated as rate sensitive if

i) within the time bucket under consideration, there is a cash flow;

ii) the interest rate resets/reprices contractually during the time buckets;

iii) administered rates are changed and iv) it is contractually prepayable or withdrawal

allowed before contracted maturities.

Thus, Gap = RSA – RSL; Gap Ratio = RSAs/RSLs. This gap is used as a measure of

interest rate sensitivity. The positive or negative gap is multiplied by the assumed interest

changes to derive the Earnings at Risk (EaR). A bank benefits from a positive Gap

(RSA>RSL), if interest rate rises. Similarly, a negative Gap (RSA<RSL) is advantageous

during the period of falling interest rate. The interest rate risk is minimized if the gap is

near zero.

Gap analysis was widely adopted by financial institutions during the 1980s. When used to manage

interest rate risk, it was used in tandem with duration analysis. Both techniques have their own

strengths and weaknesses. Duration analysis summarizes, with a single number, exposure to

parallel shifts in the term structure of interest rates. Though gap analysis is more cumbersome and

less widely applicable, it addresses exposure to other term structure movements, such as tilts or

bends. It also assesses exposure to a greater variety of term structure movements.

Table-I

Selected Items from the P&L A/c and Balance Sheet for the years 2010-11,2011-12, 2012-13

Rs. In Crores

Items 2010-11 2011-12 2012-13

Interest 48,867.96 63,230.37 75,325.80

Interest Earned 81,394.36 106,521.45 119,657.10

Provisions & Liabilities105,248.39 80,915.09 95,455.07

Deposits 933,932.81 1,043,647.36 1202,739.57

Borrowings 119,568.96 127,005.57 169,182.71

Advances 756,719.45 867,578.89 1,045,616.55

Investments 295,600.57 312,197.61 350,927.27

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• Interest rate for assets has been arrived at taking into account advances & investment portfolio

and the interest earnings of the bank for the respective years.

i.e.,Interest Rate = (Interest Earned) / (Total Advances – NPA + Total Investment).

• Interest rate for liabilities has been arrived at taking into account the deposits & borrowings

portfolio and the interest expenditure of the bank for the respective years. i.e., Interest Rate =

(Interest Expended) / (Total Deposits + Total Borrowings).

Net Interest Income (NII), Net Interest Margin (NIM), Gap and Net Income (NI) for

2010-11 to 2011-12 should be calculated. The formulae used are

NII = (Rate of RSA * Volume of RSA)

+ (Rate of FRA * Volume of FRA)

- (Rate of RSL * Volume of RSL)

- (Rate of FRL * Volume of FRL) NIM = NII/Total Performing Assets

GAP = RSA – RSL

NI = NII – Provisions & Contingencies

GAPPosition

Change in InterestRates

Change in Interestincome

Change in Interestexpenses

Change inNII

Positive Increase Increase Increase Increase

Positive Decrease Decrease Decrease Decrease

Negative Increase Increase Increase Decrease

Negative Decrease Decrease Decrease Increase

Zero Increase Increase Increase None

Zero Decrease Decrease Decrease None

Data Insufficiency became a major limitation in the study due to which mainly the RSA & RSL

couldn’t be calculated. As a result many other observations couldn’t be done. Although not

completely, the further proceedings are done with the available data.

ALM initiative in IndiaReserve Bank of India has made mandatory for banks with effect from 2002 – 03

To form ALCO (Asset-Liabilities Committee) as a committee of the Board of

Directors

To track, monitor and report ALM

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Indian Scenario While most of the banks in other economies began with strategic planning for asset

liability management as early as 1970, the Indian banks remained unconcerned about the

same. Till eighties, the Indian banks continued to operate in a protected environment. In

fact, the deregulation that began in international markets during the 1970s almost

coincided with the nationalization of banks in India during 1969. Nationalization brought

a structural change in the Indian banking sector. Wholesale banking paved the way for

retail banking and there has been an all-round growth in branch network, deposit

mobilization and credit disbursement. The Indian banks did meet the objectives of

nationalization, as there was overall growth in savings, deposits and advances. But all this

was at the cost of profitability of the banks. Quality was subjugated by quantity, as loan

sanctioning became a mechanical process rather than a serious credit assessment

decision. Political interference has been an additional malady.

A typical study is done on ALM keeping focus on Basel-II accord as

it deals with many important points regarding ALM in commercial

banks.

Paradigm ShiftAs the real sector reforms began in 1992, the need was felt to restructure the Indian banking

industry. The reform measures necessitated the deregulation of the financial sector, particularly the

banking sector. The initiation of the financial sector reforms, brought about a paradigm shift in the

banking industry. The Narasimham Committee report on the banking sector reforms highlighted the

weaknesses in the Indian banking system and suggested reform measures based on the Basle norms.

The guidelines that were issued subsequently laid the foundation for the reformation of Indian

banking sector. The deregulation of interest rates and the scope for diversified product profile gave

the banks greater leeway in their operations. New products and new operating styles exposed the

banks to newer and greater risks. Though the types of risks and their dimensions grew, there was

not much being done by the banks to address the situation. At this point, the Reserve Bank of India,

the chief regulator of the Indian banking industry, has donned upon itself the responsibility of

initiating risk management practices by banks. Moving in this direction, the RBI announced the

prudential norms relating to Income Recognition, Asset Classification and Provisioning and the

Capital Adequacy norms, for the banks. These guidelines ensured that the Indian banks followed

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international standards in risk management. The Prudential norms and the Capital Adequacy norms

are expected to ensure safety and soundness of the banks. On a closer observation, these norms

however, tackle the risks at a macro level. The capital and the provisions serve as a cushion to the

banks and ensure that they sustain in the long run. But, banks do face risks in their day-to-day

transactions, which alter their assets and liabilities on a continuous basis. The developments that

have taken place since liberalization have further led to a remarkable transition in the risk profile of

the financial intermediaries. The changes in the profile of the sources and uses of funds are

reflected in the borrower's profile, the industry profile and the exposure limits for the same, interest

rate structure for deposits and advances, etc. This not only has led to the introduction of

discriminate pricing policies, but has also highlighted the need to match the maturities of the assets

and liabilities. The main reasons for the growing significance of ALM are volatility in operating

environment, product innovations, regulatory prescriptions, enhanced awareness of top

management, high percentage of the non-performing loans in India attributed to the stringent asset

classification norms, which the Indian banks follow. Asset Liability Management is strategic

balance sheet management of risks caused by changes in the interest rates, exchange rates and the

liquidity position of the bank. To manage these risks, banks will have to develop suitable models

based on its product profile and operational style. Ironically, many Indian banks are yet not ready to

take the required initiative for this purpose. Though the reasons for such lack of initiative are

varied, one important reason can be that the management of the banks has so far been in a protected

environment with little exposure to the open market. It was lack of technology and inadequate MIS,

which prevented banks from moving towards effective ALM. The apathy on the part of the banks

made it imperative for the RBI to step in and push the process.

Basel II Accord: Impact On Indian BanksPillar 1 (minimum capital requirements): It spells out the capital requirement of a bank in

relation to the credit risk in its portfolio, which is a significant change from the “one size fits all”

approach of Basel I. Pillar 1 allows flexibility to banks and supervisors to choose from among the

Standardized Approach, Internal Ratings Based Approach, and Securitization Framework methods

to calculate the capital requirement for credit risk exposures. Besides, Pillar 1 sets out the allocation

of capital for operational risk and market risk in the trading books of banks.

Pillar 2 (supervisory oversight): It provides a tool to supervisors to keep checks on the adequacy

of capitalization levels of banks and also distinguish among banks on the basis of their risk

management systems and profile of capital. Pillar 2 allows discretion to supervisors to

(a) link capital to the risk profile of a bank;

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(b) take appropriate remedial measures if required; and

(c) Ask banks to maintain capital at a level higher than the regulatory minimum.

Pillar 3 (market discipline and disclosures): It provides a framework for the improvement of

banks’ disclosure standards for financial reporting, risk management, asset quality, regulatory

sanctions, and the like. The pillar also indicates the remedial measures that regulators can take to

keep a check on erring banks and maintain the integrity of the banking system. Further, Pillar 3

allows banks to maintain confidentiality over certain information, disclosure of which could impact

competitiveness or breach legal contracts. It provides a framework for the improvement of banks’

disclosure standards for financial reporting, risk management, asset quality, regulatory sanctions,

and the like.

An IllustrationA typical bank portfolio has an exposure to retail loans, mortgage loans, personal/credit card loans,

corporate loans, cash credit, working capital demand loans, corporate bonds and commercial

papers. For illustration, we have considered a bank with exposures to these loans segments and

applied the current and new risk weights (under Basel II). Typically, a bank’s corporate loan

portfolio including cash credit and working capital demand loans has mostly unrated exposures.

External ratings are used more in the investment portfolio, for investing in debentures, bonds, and

commercial paper (typically

A1+/A1), lowering the proportion of unrated exposures. Thus, implementation of Basel II would

result in a marginally lower credit risk weights and a marginal release in regulatory capital needed

for credit risk. As a result, we expect for most banks, Basel II would result in reduction in

regulatory credit risk weights. However, if the banks were to significantly increase their retail

exposures or get external ratings for the short-term exposures (cash credit, overdraft and working

capital demand loans), the credit risk weights could decline significantly.

Operational Risk Capital allocation would be a drag on capital for Indian banks

Basel II has indicated three methodologies for measuring operational risk:

Basic Indicator Approach;

Standardized Approach; and

Advanced Measurement Approach (AMA).

RBI has clarified that banks in India would follow the Basic Indicator Approach to begin with.

Subsequently, only banks that are able to demonstrate better risk management systems would be

asked to migrate to the Standardised Approach and AMA. Internationally, in the US, as various

papers indicate, very few banks would eventually migrate to AMA, whereas in the EU, regulators

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have stated that they would make AMA mandatory for banks under their jurisdiction. The Basic

Indicator approach specifies that banks should hold capital charge for operational risk equal to the

average of the 15% of annual positive gross income over the past three years, excluding any year

when the gross income was negative. Gross income is defined as net interest income and non-

interest income, grossed up for any provisions, unpaid interests and operating expenses (such as

fees paid for outsourced services). It should only exclude treasury gains/losses from banking book

and other extraordinary and irregular income (such as income from insurance).

Basis of ALM Traditional system of Accrual Accounting in Banks

The method disguised possible risks arising from how the assets and liabilities

were structured

Example

Saral Bank borrows Rs 100 mn for 1 yr @ 6.00% p.a. and lends to Reputation

Ltd. for 5 yrs @ 6.20% p.a.

Gain (seemingly): 20 bps

Risk entailed in transaction: borrow again at the end of 1 yr to finance the loan

which still has 4 more yrs to mature

Interest rate for 4 yrs maturity at the end of 1 yr: 7.00% p.a.

What happens??

Earn – 6.20% p.a. & Pay – 7.00% p.a.!!

Accrual method of accounting

Asset = 100*(1.062) = Rs 106.2 mn

Liability = 100*(1.060) =Rs 106 mn

Earnings = 106.2 – 106 =Rs 0.2 mn

Market Value method of accounting

Asset = 100*(1.062)^5/ (1.070)^4 = 96.72 mn

Liability = 100*(1.060) = Rs 106 mn

Loss = Rs 9.28 mn

Root cause of problem – Mismatch between Assets & Liabilities

ALM Components

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CHAPTER-5:

FINDINGS & SUGGESSIONS

5.1 FindingsImplementation of Basel II is likely to improve the risk management systems of banks as the banks

aim for adequate capitalisation to meet the underlying credit risks and strengthen the overall

financial system of the country. In India, over the short term, commercial banks may need to

augment their regulatory capitalisation levels in order to comply with Basel II. However, over the

long term, they would derive benefits from improved operational and credit risk management

practices.

Among all groups, SBI & Associates have best asset- liability maturity pattern.

They have the best correlation between assets and liabilities.

Other than Foreign Banks - all other banks can be called liability managed banks.

They all borrow from money market to meet their maturing liabilities.

Across all banks Fixed Asset and Net Worth are highly correlated.

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All banks have proportionate Net worth and investment in Fixed Asset.

Private Banks are aggressive in profit generation e Banks have better Net Profit Margin and.

Return on Net worth.

Private Banks have greater equity multiplier than public sector banks, which reflects extra

leverage that they have.

After 2002, public sector banks are catching up with private banks.

5.2 Suggestions:-1. Interest rate risk and liquidity risks are significant risks in a bank’s balance sheet, which should

be regularly monitored and managed. These two aspects should be a key input in business planning

process of a bank.

2. Banks should make sure that increased balance sheet size should not result in excessive asset

liability mismatch resulting in volatility in earnings.

3. There should be proper limit structures, which should be monitored by Asset Liability

Management Committee (ALCO) on a regular basis. Do involve all ALCO members in decisions.

Some functional heads may not be interested. It is best to have someone as a salesman for ALCO to

sell ideas, how important these ideas are to implement central systems for better benefits for bank.

4. The effectiveness of ALM system should be improved with a good Fund Transfer Pricing

system.

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5. Have a younger person, enthusiastic in nature as ALCO secretary. This person is responsible for

all pre-ALCO analysis and distribution of ALM reports to relevant people.

6. Do not deliberate a lot over non-term product distribution. It is anyway a probabilistic cash flow.

Worry more about systems in place to constantly review this.

7. ALM sheet item granularity depends on distribution for non-term products. For example,

‘savings bank’ may be one heading or ‘savings bank – salaries’ could be the level at which

distribution of volatility differs. Thus, discuss these items beforehand.

8. Define functional objectives completely before starting this project. Do not keep tampering with

it.

9. Senior management may refer to well known books on this subject to get a quick revision.

10. Do not over-engineer your ALM sheet. Let it evolve.

11. Results of ALM are visible over a couple of years. Keep measuring what is required.

5.3 Conclusion Based on the empirical findings, it can be concluded that ownership and structure of the banks do

have a major bearing in the ALM procedure. It is further observed that SBI and its Associates have

the best correlation, thereby indicating the best asset-liability maturity pattern. Most of the Indian

banks, unlike foreign banks, are liability-managed banks because they all borrow from money

market to meet their maturing liabilities. The private banks are highly aggressive for profit

generation and use the short-term funds for long-term investments. The interest rate and liquidity

risks are the significant risks that affect the bank’s balance sheet and therefore, they should be

regularly evaluated and managed. For the private banks, they use a risky strategy in case of

problems arising from the significant risks as has been mentioned above. The nationalized banks

along with SBI and its Associates are excessively concerned about liquidity and in the process; they

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use long-term funds for long- as well as medium- and short-term loans. The MIS of banks should

be strengthened up to the mark.

BIBLIOGRAPHY:-

RBI WEBSITE

ASIA PACIFIC JOURNAL ON ALM

DASH M, VENKATESH K.A, BHARGAVA B.D; “AN ANALYSIS OF ASSET-

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