Asset-Liability Asset-Liability Management in BanksManagement in Banks

KAMAL K JINDALKAMAL K JINDALkamaljindal@hotmail.comkamaljindal@hotmail.com

Asset-Liability Management (ALM)Asset-Liability Management (ALM) Bankers make decisions every day about buying Bankers make decisions every day about buying

and selling securities, about whether to make and selling securities, about whether to make particular loans, and about how to fund their particular loans, and about how to fund their investment and lending activities. investment and lending activities.

These decisions are partly based on the outlook of These decisions are partly based on the outlook of interest rates. Further, bankers take into account interest rates. Further, bankers take into account the composition of their assets and liabilities, as the composition of their assets and liabilities, as well as the degree of risk they are willing to take. well as the degree of risk they are willing to take.

The process of making such decisions is known as The process of making such decisions is known as asset-liability management (ALM). The Asset asset-liability management (ALM). The Asset Liability Management Committee (ALCO) has the Liability Management Committee (ALCO) has the overall responsibility for managing the sources and overall responsibility for managing the sources and uses of funds on the balance sheet and off-balance uses of funds on the balance sheet and off-balance sheet activities with respect to interest rate risk sheet activities with respect to interest rate risk and liquidity.and liquidity.

ALM is generally viewed as short-term in nature, ALM is generally viewed as short-term in nature, with the aim of achieving near-term financial goals. with the aim of achieving near-term financial goals.

Liquidity Risk ManagementLiquidity Risk Management

The object of any ALM policy is ensuring The object of any ALM policy is ensuring both profitability and liquidity. both profitability and liquidity.

Usually a bank maintains profitability by Usually a bank maintains profitability by borrowing short and lending long.borrowing short and lending long.

However, in order to ensure that a However, in order to ensure that a potentially illiquid position is avoided, potentially illiquid position is avoided, maturity matching has to be ensured.maturity matching has to be ensured.

A bank generally aims to eliminate the A bank generally aims to eliminate the liquidity risk while it only tries to manage liquidity risk while it only tries to manage the interest rate risk. This is because the interest rate risk. This is because elimination of interest rate risk is not elimination of interest rate risk is not profitable. profitable.

Liquidity Risk ManagementLiquidity Risk Management

In liquidity risk management, the focus is on the In liquidity risk management, the focus is on the liquidity position of the bank. The bank would liquidity position of the bank. The bank would estimate its cash requirements and the cash estimate its cash requirements and the cash inflows and adjust these two to ensure a safe inflows and adjust these two to ensure a safe level for its liquidity position. level for its liquidity position.

All deposits based on their maturity fall under the All deposits based on their maturity fall under the categories: volatile funds, vulnerable funds and categories: volatile funds, vulnerable funds and stable funds. stable funds.

Volatile funds include those deposits which are Volatile funds include those deposits which are sure to be withdrawn during the period for which sure to be withdrawn during the period for which the liquidity estimate is to be made. These the liquidity estimate is to be made. These include short- term deposits. Float funds are also include short- term deposits. Float funds are also treated as volatile deposits.treated as volatile deposits.

Liquidity Risk ManagementLiquidity Risk Management Deposits which are likely to be withdrawn during the Deposits which are likely to be withdrawn during the

planning tenure are categorized as vulnerable deposits. planning tenure are categorized as vulnerable deposits. For e.g., a bank would know which part of savings For e.g., a bank would know which part of savings deposits are stable and which portion is vulnerable.deposits are stable and which portion is vulnerable.

Finally, the residual deposits are stable deposits.Finally, the residual deposits are stable deposits. Having obtained the consolidated / component-wise Having obtained the consolidated / component-wise

working funds, the bank will now have to estimate the working funds, the bank will now have to estimate the average cash and bank balances that are to be average cash and bank balances that are to be maintained. This average balance can be maintained as maintained. This average balance can be maintained as a percentage to the total working funds. This average is a percentage to the total working funds. This average is based on forecasts, and hence a safety margin should based on forecasts, and hence a safety margin should also be ensured. also be ensured.

Any balance beyond this range will necessitate Any balance beyond this range will necessitate corrective action either by deploying the surplus funds corrective action either by deploying the surplus funds or by borrowing funds to meet the deficit. This or by borrowing funds to meet the deficit. This acceptance level is, however, a dynamic figure which acceptance level is, however, a dynamic figure which will change over time.will change over time.

ALM ImplementationALM Implementation

RBI has initiated an ALM framework in India RBI has initiated an ALM framework in India based on Gap Analysis. based on Gap Analysis.

Based on the RBI model, banks can segregate Based on the RBI model, banks can segregate their assets and liabilities into various maturity their assets and liabilities into various maturity buckets and also identify those assets and buckets and also identify those assets and liabilities that are interest sensitive. liabilities that are interest sensitive.

While deciding about liquidity requirements, in While deciding about liquidity requirements, in certain cases the RBI has only provided certain cases the RBI has only provided benchmarks. Liquidity limits for the different benchmarks. Liquidity limits for the different time buckets can be set by the particular bank time buckets can be set by the particular bank given its past experience of volatile and core given its past experience of volatile and core portion of savings/ current account deposits. portion of savings/ current account deposits.

Maturity Gap MethodMaturity Gap Method Initially the RBI has considered the traditional Gap Initially the RBI has considered the traditional Gap

analysis as a suitable method. Later the banks should analysis as a suitable method. Later the banks should move over to more sophisticated methods including move over to more sophisticated methods including Duration Gap analysis and Simulation Models Duration Gap analysis and Simulation Models

Each bank should set prudential limits on individual Each bank should set prudential limits on individual Gaps with the approval of the Board / Management Gaps with the approval of the Board / Management Committee. The following time buckets are considered:Committee. The following time buckets are considered:

1 to 14 days1 to 14 days 15 to 28 days15 to 28 days 29 days to 3 months29 days to 3 months Over 3 months to 6 monthsOver 3 months to 6 months Over 6 months to 1 yearOver 6 months to 1 year Over 1 year to 3 yearsOver 1 year to 3 years Over 3 years to 5 yearsOver 3 years to 5 years Over 5 yearsOver 5 years Non-sensitiveNon-sensitive

Liquidity Risk ManagementLiquidity Risk Management

RBI has suggested maturity profiling in RBI has suggested maturity profiling in terms of outflows and inflows while terms of outflows and inflows while arriving at liquidity prognosis. arriving at liquidity prognosis.

A Statement of Structural Liquidity may be A Statement of Structural Liquidity may be prepared by placing all cash inflows and prepared by placing all cash inflows and outflows in the maturity ladder. A outflows in the maturity ladder. A maturing liability will be a cash outflow maturing liability will be a cash outflow while a maturing asset will be a cash while a maturing asset will be a cash inflow. inflow.

Contingent liabilities also need to be taken Contingent liabilities also need to be taken into account.into account.

Liquidity Risk ManagementLiquidity Risk Management According to the latest guidelines, the banks may According to the latest guidelines, the banks may

adopt a more granular approach to measurement of adopt a more granular approach to measurement of liquidity risk by splitting the first time bucket (1-14 liquidity risk by splitting the first time bucket (1-14 days at present) in the Statement of Structural days at present) in the Statement of Structural Liquidity into three time buckets viz. Next day , 2-7 Liquidity into three time buckets viz. Next day , 2-7 days and 8-14 days.days and 8-14 days.

The net cumulative negative mismatches during the The net cumulative negative mismatches during the next day, 2-7 days, 8-14 days and 15-28 days next day, 2-7 days, 8-14 days and 15-28 days buckets should not exceed 5 % ,10%, 15 % and 20 buckets should not exceed 5 % ,10%, 15 % and 20 % of the cumulative cash outflows in the respective % of the cumulative cash outflows in the respective time buckets in order to recognise the cumulative time buckets in order to recognise the cumulative impact on liquidity.impact on liquidity.

The Statement of Structural Liquidity may be The Statement of Structural Liquidity may be compiled on best available data coverage, in due compiled on best available data coverage, in due consideration of non-availability of a fully networked consideration of non-availability of a fully networked environment. Banks may, however, make concerted environment. Banks may, however, make concerted and requisite efforts to ensure coverage of 100 per and requisite efforts to ensure coverage of 100 per cent data in a timely manner.cent data in a timely manner.

Liquidity Risk ManagementLiquidity Risk Management

Banks may undertake dynamic liquidity Banks may undertake dynamic liquidity management and should prepare the Statement of management and should prepare the Statement of Structural Liquidity on daily basis. The Statement of Structural Liquidity on daily basis. The Statement of Structural Liquidity, may, however, be reported to Structural Liquidity, may, however, be reported to RBI, once a month, as on the third Wednesday of RBI, once a month, as on the third Wednesday of every month.every month.

Within each time bucket there could be mismatches Within each time bucket there could be mismatches depending upon cash inflows and outflows. While depending upon cash inflows and outflows. While the mismatches up to one year would be relevant, the mismatches up to one year would be relevant, the main focus should be on the short term the main focus should be on the short term mismatches, viz. 1-14 days and 15-28 days. mismatches, viz. 1-14 days and 15-28 days.

Further, in order to enable banks to monitor their Further, in order to enable banks to monitor their short-term liquidity on a dynamic basis over a time short-term liquidity on a dynamic basis over a time horizon from 1-90 days, banks may estimate their horizon from 1-90 days, banks may estimate their short-term profiles on the basis of business short-term profiles on the basis of business projections and other commitments for planning projections and other commitments for planning purposes.purposes.

A Typical Example: Liquidity AspectsA Typical Example: Liquidity Aspects

Liquidity risk management prescriptions:Liquidity risk management prescriptions: The tenor profiles of the Bank’s assets and The tenor profiles of the Bank’s assets and

liabilities are classified as under:liabilities are classified as under: Short-term: Maturities up to 6 months,Short-term: Maturities up to 6 months, Medium-term: Maturities in excess of six months Medium-term: Maturities in excess of six months

and up to five yearsand up to five years Long-term:Maturities in excess of five yearsLong-term:Maturities in excess of five years `Liquidity’ will be monitored by ALCO through `Liquidity’ will be monitored by ALCO through

Balance Sheets as well as cash flow Balance Sheets as well as cash flow approaches.The following key ratios will be used approaches.The following key ratios will be used to monitor stock levels.to monitor stock levels.

A Typical Example: Liquidity AspectsA Typical Example: Liquidity Aspects

Liquidity Tolerance Limits: As per RBI guidelines, Liquidity Tolerance Limits: As per RBI guidelines, the mismatch (negative gap) may not exceed the mismatch (negative gap) may not exceed 20% of cash outflows in each of the first two 20% of cash outflows in each of the first two buckets (1-14 days & 15 – 28 days)buckets (1-14 days & 15 – 28 days)

Limit for Cumulative Mismatch (Negative Gap) in Limit for Cumulative Mismatch (Negative Gap) in individual buckets: The cumulative mismatch individual buckets: The cumulative mismatch (cumulative negative gap) should not be more (cumulative negative gap) should not be more than 25% of the cumulative inflows of the than 25% of the cumulative inflows of the respective bucket.respective bucket.

The cumulative mismatch (negative gap) in `6 The cumulative mismatch (negative gap) in `6 months to 1 year’ time bucket should not be months to 1 year’ time bucket should not be more than (-) 2% of the working funds.more than (-) 2% of the working funds.

Some Key Liquidity RatiosSome Key Liquidity Ratios

Loan to deposit ratio = Performing loans Loan to deposit ratio = Performing loans outstanding/ Deposit balances outstandingoutstanding/ Deposit balances outstanding

Incremental loan to deposit ratio = Incremental Incremental loan to deposit ratio = Incremental loans to deposits during the period/ Incremental loans to deposits during the period/ Incremental deposit inflows during the same perioddeposit inflows during the same period

Medium term funding ratio = Liabilities with maturity Medium term funding ratio = Liabilities with maturity over one year/ Assets with maturity over one yearover one year/ Assets with maturity over one year

Cash flow coverage ratio = Projected cash inflow/ Cash flow coverage ratio = Projected cash inflow/ Projected cash outflowProjected cash outflow

Liquid assets ratio = Liquid assets/ Short term Liquid assets ratio = Liquid assets/ Short term liabilitiesliabilities

Contingent liabilities ratio = Contingent liabilities/ Contingent liabilities ratio = Contingent liabilities/ Total loansTotal loans

A Typical Example: Prudential RatiosA Typical Example: Prudential Ratios

RatioRatio Desired Desired Level/ Level/ RangeRange

Level Level March March 20012001

Level Level March March 20022002

Level Level March March 20032003

Loans to Total AssetsLoans to Total Assets 45- 50%45- 50% 40%40% 38%38% 38.8638.86%%

Loans to Core DepositsLoans to Core Deposits 55-60%55-60% 57%57% 58%58% 61.0561.05%%

Liquid Assets to Total Liquid Assets to Total AssetsAssets

15-20%15-20% 17%17% 17%17% 17.5817.58%%

Liquid Assets to Liquid Assets to DepositsDeposits

20-25%20-25% 21%21% 22%22% 22.3022.30%%

Purchased Funds to Purchased Funds to Total AssetsTotal Assets

Not Not more more

than 5%than 5%

0.51%0.51% 0.35%0.35% 0.18%0.18%

A Typical Example: Prudential RatiosA Typical Example: Prudential Ratios RatioRatio Desired Desired

Level/ Level/ RangeRange

Level Level March March 20022002

Level Level March March 20032003

Long Term Assets Funding Long Term Assets Funding Through Long Term Through Long Term LiabilitiesLiabilities

Not less Not less than 50%than 50%

85%85% 92.36%92.36%

Cash and Near Assets to Cash and Near Assets to Total AssetsTotal Assets

Not more Not more than 5%than 5%

4.58%4.58% 6.85%6.85%

High value deposits (> High value deposits (> Rs.10cr) to Aggregate Rs.10cr) to Aggregate DepositsDeposits

Not more Not more than 15% than 15%

12.26%12.26% 8.99%8.99%

Off balance sheet exposures Off balance sheet exposures to Gross Assetsto Gross Assets

Not more Not more than 20%than 20%

7.99%7.99%

Trading Book to InvestmentsTrading Book to Investments Not more Not more than 5%than 5%

0.76%0.76%

Credit/ Investment RatioCredit/ Investment Ratio 1:11:1 0.85:10.85:1 0.81:10.81:1

Managing Interest Rate RiskManaging Interest Rate Risk Before the liberalisation of the financial markets in Before the liberalisation of the financial markets in

1991, most of the interest rates were not subject 1991, most of the interest rates were not subject to regular changes, and hence ALM was not given to regular changes, and hence ALM was not given much importance. However, in recent years, there much importance. However, in recent years, there has been a sea-change in approach.has been a sea-change in approach.

Today management of bank portfolios involves Today management of bank portfolios involves managing both assets and liabilities.managing both assets and liabilities.

On balance sheet adjustment involves changing On balance sheet adjustment involves changing the portfolio of assets and liabilities includes steps the portfolio of assets and liabilities includes steps such as adjusting the maturity, repricing, and such as adjusting the maturity, repricing, and payment schedules. In addition, the bank could payment schedules. In addition, the bank could buy or sell securitised assets. buy or sell securitised assets.

Off-Balance Sheet adjustments include changing Off-Balance Sheet adjustments include changing the interest position of a bank by using off-balance the interest position of a bank by using off-balance sheet derivatives, such as interest rate swaps and sheet derivatives, such as interest rate swaps and futures.futures.

Concept of Net Interest IncomeConcept of Net Interest Income

The net interest income (NII) = Interest Income – The net interest income (NII) = Interest Income – Interest Expense = (8 – 3.6) mio = 4.4 mioInterest Expense = (8 – 3.6) mio = 4.4 mio

Net Interest Margin (NIM) = NII/ Earning Assets = Net Interest Margin (NIM) = NII/ Earning Assets = 4.4/100 = 4.4%.4.4/100 = 4.4%.

If market rates of interest increase, the cost of If market rates of interest increase, the cost of short-term borrowings will increase, and NII will short-term borrowings will increase, and NII will decrease as loans are at long –term fixed rates. On decrease as loans are at long –term fixed rates. On the other hand, if market rates of interest decrease, the other hand, if market rates of interest decrease, then NII will increase.then NII will increase.

The mix of all the assets and liabilities will decide The mix of all the assets and liabilities will decide the net effect on NII. the net effect on NII.

LiabilitiesLiabilities AssetsAssets

Equity 10 Equity 10 miomio

5– yr fixed rate loans @8% 100 5– yr fixed rate loans @8% 100 miomio

30-day deposits@4% 90 30-day deposits@4% 90 miomio

Total 100 Total 100 miomio

Total Total 100 mio100 mio

Maturity Gap MethodMaturity Gap Method

The maturity gap method of ALM technique aims The maturity gap method of ALM technique aims to tackle the interest rate risk by highlighting the to tackle the interest rate risk by highlighting the gap that exists between the Risk Sensitive Assets gap that exists between the Risk Sensitive Assets (RSAs) and Risk Sensitive Liabilities (RSLs), the (RSAs) and Risk Sensitive Liabilities (RSLs), the maturity periods of the same and the gap period. maturity periods of the same and the gap period. The objective of this method is to stabilize/ The objective of this method is to stabilize/ improve the net interest income in the short run improve the net interest income in the short run over discrete periods of time called the gap over discrete periods of time called the gap periods. periods.

The first step is to collect the gap periods, say The first step is to collect the gap periods, say anywhere between one month to one year. anywhere between one month to one year. Having chosen the gap periods, all the RSAs and Having chosen the gap periods, all the RSAs and RSLs are grouped into `maturity buckets’ based RSLs are grouped into `maturity buckets’ based on the maturity and the time until the first on the maturity and the time until the first possible repricing due to change in interest rates. possible repricing due to change in interest rates.

Maturity Gap MethodMaturity Gap Method

Rate Sensitive Gap (RSG) = RSAs – RSLsRate Sensitive Gap (RSG) = RSAs – RSLs Also Gap Ratio or Interest Rate Sensitivity Ratio Also Gap Ratio or Interest Rate Sensitivity Ratio

= RSAs/ RSLs= RSAs/ RSLs The gap so analysed can be used by the treasury The gap so analysed can be used by the treasury

department to tackle the rising/ falling interest rate department to tackle the rising/ falling interest rate structures. structures.

For example, when RSG is positive, the consequence For example, when RSG is positive, the consequence of a rate fluctuation is an increase in the net interest of a rate fluctuation is an increase in the net interest income when the interest rates rise and a decrease income when the interest rates rise and a decrease in the same when the rates fall. The opposite is true in the same when the rates fall. The opposite is true when RSG is negative: the consequence of a rate when RSG is negative: the consequence of a rate fluctuation is a decrease in the net interest income fluctuation is a decrease in the net interest income when the interest rates rise and an increase in the when the interest rates rise and an increase in the same when rates fall. same when rates fall.

Maturity Gap MethodMaturity Gap Method

The process of maturity gap approach assesses the The process of maturity gap approach assesses the impact of a percentage change in interest rates on impact of a percentage change in interest rates on Net Interest Income (NII). The objective of an ALM Net Interest Income (NII). The objective of an ALM policy will be to maintain the NIM (net interest policy will be to maintain the NIM (net interest margin) within certain limits by managing the risks.margin) within certain limits by managing the risks.

The following steps are therefore involved for a The following steps are therefore involved for a bank:bank:

Assess the percentage change in NIM that is Assess the percentage change in NIM that is acceptable to the bankacceptable to the bank

Make a forecast for the quantum and direction of Make a forecast for the quantum and direction of the interest rate changethe interest rate change

Based on the above determine the gap level Based on the above determine the gap level (positive/ negative) (positive/ negative)

GAP and Net Interest Margin ExampleGAP and Net Interest Margin Example

(Rs. In Crores)(Rs. In Crores) Bank ABank A Bank BBank B

Total AssetsTotal Assets 10001000 10001000

RSAsRSAs 4040 400400

RSLsRSLs 2020 200200

GAP (RSAs – RSLs)GAP (RSAs – RSLs) 2020 200200

GAP ratio (RSAs/RSLs)GAP ratio (RSAs/RSLs) 22 22

NII (assumed)NII (assumed) 200200 200200

Decease in interest rateDecease in interest rate 2%2% 2%2%

Change in NII (GAP x Change in NII (GAP x ΔΔr)r) -0.4-0.4 -4-4

Note: In the above example, even though the asset size and Note: In the above example, even though the asset size and the GAP ratio are identical for both banks, it is evident that the GAP ratio are identical for both banks, it is evident that Bank B assumes greater risk since its interest income will be Bank B assumes greater risk since its interest income will be more volatile when interest rates change.more volatile when interest rates change.

Limitations of Maturity Gap ApproachLimitations of Maturity Gap Approach

Depends upon accuracy of interest rate Depends upon accuracy of interest rate forecasts – may not be correctforecasts – may not be correct

While gap measurement is a While gap measurement is a comparatively easy task, gap comparatively easy task, gap management is not. management is not.

It assumes that change in interest rates It assumes that change in interest rates immediately affects the RSAs and RSLs by immediately affects the RSAs and RSLs by the same quantum which is not always the the same quantum which is not always the case in reality.case in reality.

Ignores the time value of money for the Ignores the time value of money for the cash flows while determining the gapcash flows while determining the gap

ALM StrategiesALM Strategies

The size of the net interest income can be The size of the net interest income can be controlled through defensive or aggressive ALM. controlled through defensive or aggressive ALM.

The goal of defensive ALM is to insulate the NII from The goal of defensive ALM is to insulate the NII from changes in interest rates; that is, to prevent changes in interest rates; that is, to prevent interest rate changes from decreasing or increasing interest rate changes from decreasing or increasing NII. In contrast, aggressive ALM focuses on NII. In contrast, aggressive ALM focuses on increasing NII through altering the portfolio of the increasing NII through altering the portfolio of the institution. institution.

The success of aggressive ALM depends on the The success of aggressive ALM depends on the ability to forecast future interest rate changes. ability to forecast future interest rate changes. However, if interest rate changes do not move the However, if interest rate changes do not move the way predicted, this strategy can lead to losses, and way predicted, this strategy can lead to losses, and hence risky. hence risky.

The focus of the defensive strategy is to insulate The focus of the defensive strategy is to insulate the portfolio from interest rate changes, whether the portfolio from interest rate changes, whether the direction of the interest rate movement is the direction of the interest rate movement is upward or downward, predictable or unpredictable. upward or downward, predictable or unpredictable.

How much interest rate risk is How much interest rate risk is acceptable?acceptable?

One of the most difficult decisions that bank One of the most difficult decisions that bank managers face is determining the appropriate managers face is determining the appropriate degree of interest rate risk to assume. degree of interest rate risk to assume.

At one extreme, referred to as defensive interest At one extreme, referred to as defensive interest rate risk management, the bank would attempt to rate risk management, the bank would attempt to structure its assets and liabilities in order to structure its assets and liabilities in order to eliminate interest rate risk. However, the eliminate interest rate risk. However, the profitability of a bank that does not take some profitability of a bank that does not take some interest risk would be inadequate. interest risk would be inadequate.

No one has perfect foresight with respect to No one has perfect foresight with respect to interest rates. However, high-risk strategies interest rates. However, high-risk strategies combined with imperfect forecasts of interest rate combined with imperfect forecasts of interest rate movements can result in disaster.movements can result in disaster.

Duration Gap AnalysisDuration Gap Analysis

The deficiencies of traditional gap analysis, The deficiencies of traditional gap analysis, especially the focus on accounting income especially the focus on accounting income rather than on equity, have encouraged a rather than on equity, have encouraged a search for alternative approaches to search for alternative approaches to measuring and managing the interest rate measuring and managing the interest rate exposure of a financial institution. One such exposure of a financial institution. One such approach is duration gap analysis.approach is duration gap analysis.

““Duration” may be defined as the weighted Duration” may be defined as the weighted average time (measured in years) to receive average time (measured in years) to receive all cash flows from a financial instrument.all cash flows from a financial instrument.

DurationDuration We could also say that a bond portfolio is We could also say that a bond portfolio is

immunized from the interest rate risk if immunized from the interest rate risk if the duration of the portfolio is equal to the the duration of the portfolio is equal to the desired holding period.desired holding period.

Finally, the duration of a portfolio will keep Finally, the duration of a portfolio will keep changing with time. Hence, rebalancing of changing with time. Hence, rebalancing of the portfolio on an annual or as needed the portfolio on an annual or as needed basis will have to be carried out. basis will have to be carried out.

Duration GapDuration Gap

The duration gap is the difference between The duration gap is the difference between the durations of a bank’s assets and the durations of a bank’s assets and liabilities. It is a measure of interest rate liabilities. It is a measure of interest rate sensitivity that helps to explain how sensitivity that helps to explain how changes in interest rates affect the market changes in interest rates affect the market value of a bank’s assets and liabilities, and value of a bank’s assets and liabilities, and in turn, its net worth.in turn, its net worth.

The net worth is the difference between The net worth is the difference between assets and liabilities, i.e. NW = A – L.assets and liabilities, i.e. NW = A – L.

By using duration, we can calculate the By using duration, we can calculate the theoretical effects of interest rate changes theoretical effects of interest rate changes on net worth: on net worth: ΔΔNW = NW = ΔΔA – A – ΔΔL, where L, where ΔΔ is is change in value.change in value.

Measurement of Duration GapMeasurement of Duration Gap

Balance Sheet DurationBalance Sheet Duration

LiabilitiesLiabilities Rs. MioRs. Mio Duration Duration (Years)(Years)

AssetsAssets Rs. MioRs. Mio Duration Duration (Years)(Years)

CD, 1 yearCD, 1 year 600600 1.001.00 CashCash 100100 0.000.00

DebentureDebentures, 5 yearss, 5 years

300300 5.005.00 Business Business loansloans

400400 1.251.25

Total Total LiabilitiesLiabilities

900900 2.332.33 MortgagMortgage loanse loans

500500 7.007.00

EquityEquity 100100

TotalTotal 10001000 TotalTotal 10001000 4.004.00

Measurement of Duration GapMeasurement of Duration Gap

In the above case, duration has been In the above case, duration has been calculated for the assets and liabilities in the calculated for the assets and liabilities in the following manner.following manner.

It is assumed that CDs as well as Debentures It is assumed that CDs as well as Debentures pay interest once only, at maturity. pay interest once only, at maturity.

The duration of each of the assets and The duration of each of the assets and liabilities is given. Cash has zero duration. liabilities is given. Cash has zero duration.

Except for zero coupon securities where only Except for zero coupon securities where only a single payment occurs, duration is always a single payment occurs, duration is always less than maturity. The duration of the CDs less than maturity. The duration of the CDs and Debentures are the same as their and Debentures are the same as their maturities, because they are single payment maturities, because they are single payment liabilities.liabilities.

Measurement of Duration GapMeasurement of Duration Gap The duration gap (DGAP) is measured as follows: The duration gap (DGAP) is measured as follows: DGAP = DDGAP = Daa – WD – WDLL, where D, where Daa = Average duration of = Average duration of

assets, Dassets, DLL = Average duration of liabilities, and W = = Average duration of liabilities, and W = Ratio of total liabilities to total assets.Ratio of total liabilities to total assets.

Thus, DGAP = 4.0 – (0.9)(2.33) = 4.00 – 2.10 = 1.90 Thus, DGAP = 4.0 – (0.9)(2.33) = 4.00 – 2.10 = 1.90 yrs. yrs.

Further, to arrive at an approximation for the Further, to arrive at an approximation for the expected change in the market value of the equity expected change in the market value of the equity relative to total assets (TA):relative to total assets (TA):

ΔΔNet Worth/ TA ≈ - DGAP[Net Worth/ TA ≈ - DGAP[ΔΔ i/(1+i)] or for Rs. i/(1+i)] or for Rs. Change in net worth: Rs. Change in net worth: Rs. ΔΔnet worth ≈ - DGAP [net worth ≈ - DGAP [ΔΔ i/(1+i)] x TAi/(1+i)] x TA

Suppose that current interest rates are 11% and are Suppose that current interest rates are 11% and are expected to increase by 100 basis points. Thenexpected to increase by 100 basis points. Then

% % ΔΔ Net Worth ≈ = (-1.90)(1/1.11) ≈ -1.70% Net Worth ≈ = (-1.90)(1/1.11) ≈ -1.70% In Rs. terms, Rs. In Rs. terms, Rs. ΔΔ Net Worth ≈ (-1.90)(1/1.11) x TA Net Worth ≈ (-1.90)(1/1.11) x TA ≈ ≈ -1.7% x Rs.1000 mio = - Rs.17 mio.-1.7% x Rs.1000 mio = - Rs.17 mio.

Duration Gap ManagementDuration Gap Management

If the duration gap is positive (i.e. the duration of If the duration gap is positive (i.e. the duration of assets exceeds the duration of liabilities), then assets exceeds the duration of liabilities), then increases in interest rates will reduce the value of increases in interest rates will reduce the value of net worth, and decreases in interest rates will net worth, and decreases in interest rates will increase the value the value of net worth. increase the value the value of net worth.

Conversely, if the duration gap is negative, with the Conversely, if the duration gap is negative, with the duration of assets less than the duration of duration of assets less than the duration of liabilities, rising interest rates will increase the liabilities, rising interest rates will increase the value of net worth, whereas falling interest rates value of net worth, whereas falling interest rates will lead to a reduction. will lead to a reduction.

If the institution is immunised from changes in If the institution is immunised from changes in interest rates through a zero duration gap, changes interest rates through a zero duration gap, changes in the value of assets will be exactly offset by in the value of assets will be exactly offset by changes in the value of liabilities.changes in the value of liabilities.

Duration Gap, Interest Rates, and Changes Duration Gap, Interest Rates, and Changes in Net Worthin Net Worth

Duration GapDuration Gap Change in Change in Interest RatesInterest Rates

Change in Net Change in Net WorthWorth

PositivePositive Increase Increase DecreaseDecrease

PositivePositive DecreaseDecrease Increase Increase

NegativeNegative Increase Increase Increase Increase

NegativeNegative DecreaseDecrease DecreaseDecrease

Zero Zero Increase Increase No changeNo change

ZeroZero DecreaseDecrease No changeNo change

Duration Gap ManagementDuration Gap Management

An aggressive interest rate risk management An aggressive interest rate risk management strategy would alter the duration gap in anticipation strategy would alter the duration gap in anticipation of changes in interest rates. For example, if interest of changes in interest rates. For example, if interest rates are expected to increase, management would rates are expected to increase, management would want to shift from a positive to a negative position. It want to shift from a positive to a negative position. It could do this by reducing the duration of assets could do this by reducing the duration of assets and/or increasing the duration of liabilities. and/or increasing the duration of liabilities.

The expectation of falling interest rates would The expectation of falling interest rates would produce the opposite type of portfolio management produce the opposite type of portfolio management adjustments. adjustments.

Defensive interest rate risk management would seek Defensive interest rate risk management would seek to keep the duration of assets equal to the duration to keep the duration of assets equal to the duration of liabilities, thereby maintaining a duration gap of of liabilities, thereby maintaining a duration gap of zero. zero.

Problems of Duration Gap ManagementProblems of Duration Gap Management Immunisation will be effective only if interest rates for all maturity Immunisation will be effective only if interest rates for all maturity

securities shift up or down by exactly the same amount (i.e. only if securities shift up or down by exactly the same amount (i.e. only if the yield curve moves upward or downward by a constant the yield curve moves upward or downward by a constant percentage amount). In fact, yield curves seldom move in this percentage amount). In fact, yield curves seldom move in this way.way.

In periods of rising interest rates, short term rates usually move In periods of rising interest rates, short term rates usually move up more than long-term rates. Similarly, in periods of falling up more than long-term rates. Similarly, in periods of falling interest rates short-term interest rates usually fall more than long interest rates short-term interest rates usually fall more than long term rates.term rates.

Further, the price changes that occur in the value of a financial Further, the price changes that occur in the value of a financial asset due to interest changes is only an approximation.asset due to interest changes is only an approximation.

Duration drift : Duration drift : Another issue is the problem of duration drift. For example, let us Another issue is the problem of duration drift. For example, let us

presume that a financial institution finances a long term loan presume that a financial institution finances a long term loan (seven year duration) with a maximum of five- and ten-year (seven year duration) with a maximum of five- and ten-year duration deposits. duration deposits.

After say three years the duration of the liabilities has declined After say three years the duration of the liabilities has declined more than duration of assets. This happens because maturities more than duration of assets. This happens because maturities were not matched initially even though durations were. were not matched initially even though durations were.

ALM ImplementationALM Implementation

The consolidated data of the past, future The consolidated data of the past, future projections, macro-level trends and forecasts will projections, macro-level trends and forecasts will have to be generated at the corporate office. have to be generated at the corporate office.

Detailed internal control systems have to be laid Detailed internal control systems have to be laid down to ensure adherence to the policy framework. down to ensure adherence to the policy framework. Necessary hardware and software have to be in Necessary hardware and software have to be in place. place.

As banks become familiar with the techniques and As banks become familiar with the techniques and MIS improves, the banks are expected to move over MIS improves, the banks are expected to move over to more sophisticated and data intensive methods to more sophisticated and data intensive methods of ALM.of ALM.

The end result should be a smooth integration of the The end result should be a smooth integration of the risk management process with the bank’s business risk management process with the bank’s business strategies. strategies.

Simulation and ALMSimulation and ALM Banks in advanced countries have started using Banks in advanced countries have started using

simulation models that allow them to examine simulation models that allow them to examine alternative interest rate scenarios, and to stress-alternative interest rate scenarios, and to stress-test their portfolios.test their portfolios.

Many of the larger banks depend primarily on Many of the larger banks depend primarily on simulations, and they set limits for their interest simulations, and they set limits for their interest rate exposure. For example, a bank may limit its rate exposure. For example, a bank may limit its interest rate exposure to a 5 per cent change in interest rate exposure to a 5 per cent change in net interest income. Given this limit, it models the net interest income. Given this limit, it models the balance sheet that will constrain it to that limit balance sheet that will constrain it to that limit when interest rate changes by, say 200 basis when interest rate changes by, say 200 basis points.points.

Stress testing reveals the effects on income and Stress testing reveals the effects on income and capital of larger changes in interest rates. Stress capital of larger changes in interest rates. Stress testing can be thought of as testing the testing can be thought of as testing the implications of a worst-case scenario. implications of a worst-case scenario.

Recently EU stress testing of 91 banks in EU, 7 Recently EU stress testing of 91 banks in EU, 7 banks failed in the Test[ 5 in Spain, 1 I each in banks failed in the Test[ 5 in Spain, 1 I each in Germany and GreeceGermany and Greece