PROJECT REPORT ON

Asset Liability Management of Commercial Bank

BY

Ashish Chaurasia

UNDER THE GUIDANCE OF

Prof. Trupti Naik

A PROJECT SUBMITTED IN FULFILMENT OF MMS TO

VIDYALANKAR INSTITUTE OF TECHNOLOGY

Wadala (East), Mumbai 400 037

March 2015

PROJECT REPORT ON

1

Asset Liability Management of Commercial Bank

BY

Ashish Chaurasia

UNDER THE GUIDANCE OF

Prof. Trupti Naik

A PROJECT SUBMITTED IN FULFILMENT OF MMS TO

VIDYALANKAR INSTITUTE OF TECHNOLOGY

Wadala (East), Mumbai 400 037

March 2015

Signature of Faculty Guide Head of Department

DECLARATION

2

This is to declare that the study presented by me to Vidyalankar Institute of

Technology, in completion of the Master in Management Studies (MMS)

under the “Asset Liability Management of Commercial Bank” has been

accomplished under the guidance of prof. Trupti Naik.

Ashish Chaurasia

Place:

Date:

ACKNOWLEDGEMENT

3

My project on “Asset Liability Management of Commercial Bank’’ has been a

great learning experience. I was exposed to the different areas of research in

finance and gained valuable experience, which I will always recall with a

sense of satisfaction and pride.

This is to acknowledge Prof. Trupti Naik under whose guidance I have been able to successfully complete this project and effectively come to a very successful conclusion.

To all my colleagues who have helped me either directly or indirectly, I am grateful

for their valuable inputs. This project would not have been possible without their help.

Ashish Chaurasia

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CONTENT

1. Objective 5

2. Literatture review 6

3 INTRODUCTION OF THE TOPIC 9

4. Research Methodology 12

5. Risks associated with ALM 13

6. Strategies and Techniques used for ALM 16

7. Trends in Liquidity Risk Management 26

8. Roles of ALCO 35

9. Process of ALCO 37

10. Organisational Structure of ALCO 38

11. Trend analysis of Asset and liability component of Public sector,

Private sector and Foreign bankS 39

12 TREND OF Assets COMPONENTS IN PUBLIC SECTOR 41

13TREND OF LIABILITY COMPONENTS IN PUBLIC

SECTOR43

14 TREND OF ASSET COMPONENTS IN PRIVATE SECTOR 45

15TREND OF LIABLITY COMPONENTS IN PRIVATE

SECTOR47

16 TREND OF ASSETS COMPONENTS IN FOREIGN BANKS 49

17 TREND OF LIABILITY COMPONENTS IN FOREIGN

BANKS:51

18 Findings and Conclusion 55

19 BIBLIOGRAPHY 57

OBJECTIVE OF STUDY

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1. To understand risk associated with asset liability management in Indian

commercial banks.

2. To study strategies and techniques used for Asset liability management in

Indian commercial banks

3. Role of ALCO(Asset Liability committee) in asset liability management.

6

Literature Review:

Kanjana.E.N (2007), “Efficiency, Profitability and Growth of Scheduled Commercial Banks

in India” tested (1) whether the establishment expense was a major expense, and (2) out of total expense which is met by scheduled commercial banks is more due to more number of employees. In her empirical study, the earning factor and expense factor which are controllable and non-controllable by the bank.

Ashok Kumar.M (2009) in his study examines how the financial performance of

SBI group, Nationalized banks group, private banks group and foreign banks

group has been affected by the financial deregulation of the economy. The

main objective of the empirical study is to assess the financial performance of

Scheduled Commercial Banks through CRAMEL Analysis.

Recently, there has been much discussion regarding the concept of enterprise risk

management (ERM). ERM is a broader concept than asset liability management.

ERM can be viewed as a comprehensive and integral process of identifying,

assessing, monitoring and managing the risk exposure of an organization, ideally

through a formal organizational structure and a quality approach. The goal of

ERM is to minimize the effects of risk on an organization‟s capital and earnings,

and to better allocate its risk capital. Thus, ERM considers the broad range of risks

associated with operating a business, including financial, strategic, and operational

and hazard risks. Because financial institutions thrive on the business of risk, they

are good examples of companies that can benefit from effective ERM. Asset

liability Management is a significant component of ERM because it is an

important process in addressing financial risk since all risk cannot be eliminated

but it is the responsibility of risk managers to identify their risk levels and know

which level can be controlled or accept.

A number of authors (Hester & Zoellner, 1966; Kwast & Rose, 1982; Vasiliou, 1996; Kosmidou et al, 2004; and Asiri, 2007) have studies about the influence of the composition of assets and liabilities on the profitability of bank. Hester & Zoellner (1966) employed statistical cost accounting (SCA) method on US

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banks and found statistically significant coefficients for most of the categories of assets and liabilities and rejected the null hypothesis that there is no relationship between them. Vasiliou (1996), by employing SCA method, suggest that asset management rather than liability management play more prominent role in explaining inter-bank differences in profitability. However, these findings contrast with the findings of Kosmidou et al (2004) who find that liability management contributes more in creating the profitability differences among the banks.

These authors did not incorporate the variables relating to macro economic and market structure in their model. In fact, a number of bank specific or macroeconomic factors such as market structure, Inflation, gross domestic product (GDP) growth rate, etc do impact bank’s net earnings which were ignored by these authors. With this view, Kwast & Rose (1982) expanded the traditional SCA model by including market structure and macro economic variables. Nonetheless, their model found no evidence that differential returns and costs on different categories of assets and liabilities exist between high and low profit banks. In a recent study, Asiri (2007) has applied SCA method and finds that assets are positively and liabilities are negatively related to the profitability of the Kuwaiti banks.

The ALM area of finance has been widely studied for its use in pension funds, insurance companies, and other institutional investment portfolios (see Leibowitz and Henriksson 1988; Waring 2004a, 2004b; Fong and Guin 2007, among others). ALM has only recently begun to be examined in the context of individual investors. Numerous studies examine portfolio management of individual investors within an ALM framework. Stout (2008) presents a stochastic, Monte Carlo optimization of retirementportfolios that seeks to minimize the probability of exhausting the portfolio. He notes that the risk-minimizing allocation to equities decreases with retirement age and increases with the withdrawal rate from the portfolio. Ziemba (2003) presents an ALM methodology for managing multi-period investment horizons using a generalized stochastic program. In his article, individuals’ multi-period horizons are examined against a model that suggests an allocation for each horizon. Further, the EDHEC Risk and Asset Management Research Centre has published a number of general studies dealing with the topic of ALM for individual investors (for example, Amenc, Martellini, and Ziemann 2007).

The application of ALM for individual investors is also examined from a behavioral perspective in various studies. In these studies, liabilities are framed in terms of goals that investors wish to achieve using portfolio funds. Nevins (2004) examines goals-based investing using investor-specific liability goals and sub-portfolios (within the larger investment portfolio) that are managed to meet these goals. Chhabra (2005) also incorporates investor goals into the asset allocation decision and notes that risk allocation should precede asset allocation when managing portfolios for individual investors. Brunel (2006) examines goals-based investment techniques and compares the efficiency of these techniques to traditional allocation approaches; he

8

discovers that the additional costs associated with goals-based investing are trivial.

Jones and Brown (2009) contend that private-wealth investors are challenged in ways: (1) asset allocation advice yielded from commonly applied techniques focuses on optimization, not risk management, and (2) shortfall funding risk analysis is not typically analyzed in terms of multi-period stochastic reality. They further contend that shortfall risk analysis does not typically provide asset-allocation advice. Their study argues that straightforward and readily implementable risk-management techniques that provide insight on asset allocation are in short supply for private wealth practitioners. Jones and Brown (2009) also contend that the absence of ALM in the private wealth arena stems from two factors: (1) its perceived complexity, and (2) prior attempts to implement ALM across larger firms tended to fail because of the actual complexity of the specific implementation techniques and the associated software, among other reasons. As a result, they present a straightforward interest rate immunization technique in which low-risk assets can ultimately be used to immunize liabilities over a specified period. Further, the net present value of liabilities over the specified immunization horizon is used as a constraint within a mean-variance optimization (MVO). This approach allows an individual’s portfolio to provide short-term cash flow, as needed, while also considering the longer-term demands on the portfolio. Another interpretation of this approach is as a form of liability-driven investing with surplus optimization (Taylor and Earney 2008), which itself falls within the ALM arena. Ultimately, ALM protects against shortfall  funding risks and provides perspective on the basic mix of low-risk (immunizing) assets and riskier assets, whereas widely used asset-allocation techniques such as mean-variance optimization (MVO) focus primarily on optimizing assets. In this regard, the Jones and Brown (2009) approach allows for both liability risk managment and efficient portfolio construction.

INTRODUCTION OF THE TOPIC

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As financial intermediaries banks are known to accept deposit to lend money

to entrepreneurs to make profit. They essentially intermediate between the opposing

liquidity needs of depositors and borrowers. In the process, they function with an

embedded mismatch between highly liquid liabilities on the one side and less liquid

and long term assets on the other side of their balance sheets. Over and above this

balance sheet conflict, they also stand exposed to a wide array of risk such as market

risk, transformation risk, credit risk, liquidity risk, forex risk, legal risk, operation

risk, reputational risk, interest rate risk, etc. The recognition of three main risk i.e.

Interest Rate Risk, Liquidity Risk and Credit Risk gave rise to the concept of Asset

Liability Management.

Asset-Liability Management (ALM) can be termed as a risk management technique

designed to earn an adequate return while maintaining a comfortable surplus of assets

beyond liabilities. Banks are exposed to several risks which are multi-dimensional.

The main direct financial risks are interest rate risk, liquidity risk, credit risk and

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

management 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. The asset-liability management

function would involve planning, directing and controlling the flow, level, mix, cost

and yield of the consolidated funds of the Bank. It takes into consideration interest

rates, earning power, and degree of willingness to take on debt and hence is also

known as Surplus Management. It enables banks to sustain their required growth rate

by systematically managing market risk, liquidity risk, capital risk, etc.

The objective of ALM is to manage risk and not eliminate it. Risks and rewards go

hand in hand. One cannot expect to make huge profits without taking huge amount of

risk. The objectives do not limit the scope of the ALM functionality to mere risk

assessment, but expanded the process to the taking of risks that might conceivably

result in an increase in economic value of the balance sheet.

Apart from managing the risks ALM should enhance the net worth of the institution

through opportunistic positioning of the balance sheet. The more leveraged an

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institution, the more critical is the ALM function with enterprise.

The objectives of Asset-Liability Management are as follows:

To protect and enhance the net worth of the institution.

Formulation of critical business policies and efficient allocation of Capital.

To increase the Net Interest Income (NII)

It is a quantification of the various risks in the balance sheet and optimizing of

profit by ensuring acceptable balance between profitability, growth and risks.

ALM should provide liquidity management within the institution and choose a

model that yields a stable net interest income consistently while ensuring

liquidity.

To actively and judiciously leverage the balance sheet to stream line the

management of regulatory capital.

Funding of banks operation through capital planning.

Product pricing and introduction of new products.

To control volatility of market value of capital from market risk.

Working out estimates of return and risk that might result from pursuing

alternative

programs.

Asset/ liability management (ALM) is a tool that enables bank managements’ to

take business decisions in a more informed framework. The ALM function informs

the manager what the current market risk profile of the bank is and the impact that

various alternative business decisions would have on the future risk profile. The

manager can then choose the best course of action depending on his board's risk

appetite.

Consider for example, a situation where the chief of a bank’s retail deposit

mobilization function wants to know the kind of deposits that the branches should

be told to encourage. To answer this question correctly he would need to know

inter alia the existing cash flow profile of the bank. Let us assume that the

structure of the existing assets and liabilities of the bank are such that at the

aggregate the maturity of assets is longer than maturity of liabilities. This would

expose the bank to interest rate risk (if interest rates were to increase it would

adversely affect the banks net interest income). In order to reduce the risk the bank

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would have to either reduce the average maturity of its assets perhaps by

decreasing its holding of Government securities or increase the average maturity of

its assets, perhaps by reducing its dependence on call/money market funds. Thus,

given the above information on the existing risk profile of the bank, the retail

deposits chief knows that the bank can reduce its future risk by marketing its long-

term deposit products more aggressively. If necessary he may offer increased rates

on long-term deposits and/or decreasing rates on the shorter term deposits.

The above example illustrates how correct business decision making can be added

by the interest rate risk related information. The real world of banking is of course

more complicated. The risk related information is just one of many pieces of

information required by a manager to take decisions. In the above example itself

the retail deposits chief would also have considered a host of other factors like

competitive pressures, demand and supply factors, impact of the decision on the

banks retail lending products, etc before taking a final decision. The important

thing, however, is that ALM is a tool that encourages business decision making in

a more disciplined framework with an eye on the risks that the bank is exposed to.

ALM is thus a comprehensive and dynamic framework for measuring, monitoring

and managing the market risks, i.e liquidity interest and exchange rate risks of a

bank. It has to be closely integrated with the bank’s business strategy as this affects

the future risk profile of the bank. This framework needs to be built around a

foundation of sound methodology and human and technological infrastructure. It

has to be supported by the board's risk philosophy, which clearly specifies the risk

policies and tolerance limits. ALM is a term whose meaning has evolved. It is

used in slightly different ways in different contexts. ALM was pioneered by

financial institutions, but corporations now also apply ALM techniques.

Traditionally, banks and insurance companies used accrual accounting for

essentially all their assets and liabilities. They would take on liabilities, such as

deposits, life insurance policies or annuities. They would invest the proceeds from

these liabilities in assets such as loans, bonds or real estate. All assets and liabilities

were held at book value. Doing so disguised possible risks arising from how the

assets and liabilities were structured.

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RESEARCH METHODOLOGY

MEANING OF RESEARCH:-

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Research is a scientific & systematic search for pertinent information on a

specific topic. The Advanced Learning Dictionary of Current English lays down the

meaning of research as “careful investigation or inquiry especially through search for

new facts in any branch of knowledge”. Some people consider research as a

movement, a movement from the known to unknown. It is actually a voyage of

discovery.

In short, the search for knowledge through objective & systematic method of finding

solutions

to a problem is research.

Data Collection:

For any study there must be data for analysis purpose. Without data there is

no means of study. Data collection plays an important role in any study. It can be

collected from various sources. I have collected the data from one source which are

given below:

Secondary Data

Published Sources such as Journals, Government Reports, Newspapers and

Magazines etc.

Unpublished Sources such as Company Internal reports.

Websites like RBI, IBA

To achieve the objective, information is collected through secondary data.

Secondary

data one those which have been already been collected.

Sampling As the study was primarily based on secondary data. No sampling

technique has been used for this purpose, no sample size is applicable and no tools

were used for collecting primary data.

Hypothesis:

Trends of asset liability components in private/public sector bank is different than

foreign bank

Limitation of the studies:

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The research work is mainly based on secondary data .

Less importance has been given to primary data which is actually the original

data and more reliable.

Risk associated with Asset Liability Management

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

these include credit risk, capital risk, market risk, interest rate risk, liquidity risk,

operations risk and foreign exchange risks. These categories of financial risk require

focus, since financial institutions like banks do have complexities and rapid

changes in their operating environments.

1. Credit Risk: The risk of counter party failure in meeting the payment

obligation on the specific date is known as credit risk. Credit risk management

is an important challenge for financial institutions and failure on this front may

lead to failure of banks. Credit risk plays a vital role in the way banks perform.

It reflects the profitability, liquidity and reduced Non Performing Assets.

The other important issue is contract enforcement. Legal reforms are very

critical in order to have timely contract enforcement. Delays and loopholes in

the legal system significantly affect the ability of the lender to enforce the

contract. The legal system and its processes are notorious for delays showing

scant regard for time and money that is the

basis of sound functioning of the market system. Credit Risk Management is

the process that puts in place systems and procedures enabling banks to:

Identify and measure the risk involved in credit proposition, both at

individual transaction and portfolio level.

Evaluate the impact of exposure on bank's financial statements.

Access the capability of the risk mitigates to hedge/insure risks.

Design an appropriate risk management strategy to arrest risk mitigation.

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2.Capital Risk: Capital risk is the risk an investor faces that he or she may lose

all or part of the principal amount invested. It is the risk a company faces that it

may lose value on its capital. The capital of a company can include equipment,

factories and liquid securities. Capital adequacy focuses on the weighted average

risk of lending and to that extent, banks are in a position to realign their portfolios

between more risky and less risky assets.

3.Market Risk: Market risk refers to the risk to an institution resulting from

movements in market prices, in particular, changes in interest rates, foreign

exchange rates, and equity and commodity prices. Market risk is also referred

to as "systematic risk". This risk cannot be diversified. Market risk is related to

the financial condition, which results from adverse movement in market

prices. This will be more pronounced when financial information has to be

provided on a marked-to-market basis since significant fluctuations in asset

holdings could adversely affect the balance sheet of banks. The problem is

accentuated because many financial institutions acquire bonds and hold it till

maturity. When there is a significant increase in the term structure of interest

rates, or violent fluctuations in the rate structure, one finds substantial erosion

of the value of the securities held. Market risk is often propagated by other

forms of financial risk such as credit and market-liquidity risks. For example,

a downgrading of the credit standing of an issuer could lead to a drop in the

market value of securities issued by that issuer. Likewise, a major sale of a

relatively illiquid security by another holder of the same security could depress

the price of the security.

4.Interest Rate Risk: 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.

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Interest risk is the change in prices of bonds that could occur as a result of change

ininterest rates. In measuring its interest rate risk, an institution should

incorporate re-pricing

risk (arising from changing rate relationships across the spectrum of maturities), basis

risk

(arising from changing rate relationships among yield curves that affect the

institution's activities) and optionality risks (arising from interest rate related options

embedded in the institution's products).

There are certain measures available to measure interest rate risk. These include:

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.

4.Liquidity Risk: Liquidity Risk is the risk stemming from the lack of

marketability of an investment that cannot be bought or sold quickly enough to

prevent or minimize a loss. It is usually reflected in a wide bid- ask spread or

large price movements. It arises from the potential inability of the Bank to

generate adequate cash to cope with a decline in deposits or increase in assets.

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To a large extent, it is an outcome of the mismatch in the maturity patterns of

assets and liabilities.

There are two types of liquidity i.e. market liquidity and funding liquidity.

Liquidity risk broadly comprises three sub-types:

Funding Risk: The need to replace net outflows of funds whether due to

withdrawal of retail deposits or non-renewal of wholesale funds.

Time Risk: The need to compensate for non-receipt of expected inflows of

funds, e.g. when a borrower fails to meet his repayment commitments.

Call Risk: The need to find fresh funds when contingent liabilities become

due. Call risk also includes the need to be able to undertake new

transactions when desirable.

STRATEGIES AND TECHNIQUES USED FOR

ASSET LIABILITY MANAGEMENT

ASSET MANAGEMENT STRATEGY

Some banks had the traditional deposit base and were also capable of achieving

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substantial growth rates in deposits by active deposit mobilization drive using their

extensive branch network. For such banks the major concern was how to expand the

assets securely and profitably. Credit was thus the major key decision area and the

investment activity was based on maintaining a statutory liquidity ratio or as a

function of liquidity management. The management strategy in such banks was thus

more biased towards asset management.

LIABILITY MANAGEMENT STRATEGY

Some banks on the other hand were unable to achieve retail deposit growth rates since

they did not have a wide branch network. But these banks possessed superior asset

management skills and hence could fund assets by relying on the wholesale markets

using Call money, CD’s Bill Rediscounting etc. Deregulation of interest rates coupled

with reforms in the money market introduced by the reserve bank provided these

banks with the opportunity to compete with funds from the wholesale market using

the pricing strategy to achieve the desired volume, mix and cost. So under the

Liability management approach, banks primarily sought to achieve maturities and

volumes of funds by flexibly changing their bid rates for funds.

ALM STRATEGY

As interest rated in both the liability and the asset side were deregulated, interest rates

in various market segments such as call money, CD’s and the retail deposit rates

turned out to be variable over a period of time due to competition and the need to

keep the bank interest rates in alignment with market rates. Consequently the need to

adopt a comprehensive Asset- liability strategy emerged, the key objectives of which

were as under.

The volume, mix and cost/return of both liabilities and assets need to be planned

and monitored in order to achieve the bank’s short and long term goals.

Management control would comprehensively embrace all the business segments

like deposits, borrowing, credit, investments, and foreign exchange. It should be

coordinated and internally consistent so that the spread between the bank’s

earnings from assets and the costs of issuing liabilities can be maximized.

Suitable pricing mechanism covering all products like credit, payments, custodial

financial advisory services should be put in place to cover all costs and risks.

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STRATEGIC APPROACHES TO ALM

Spread Management: This focuses on maintaining an adequate spread between a

bank’s interest expense on liabilities and its interest income on assets.

Gap Management: This focuses on identifying and matching rate sensitive assets

and liabilities to achieve maximum profits over the course of interest rate cycles.

Interest Sensitivity Analysis : This focuses on improving interest spread by testing

the effects of possible changes in the rates, volume, and mix of assets and

liabilities, given alternative movements in interest rates.

These strategies attempt to closely co-ordinate bank assets and liability management

so that bank’s earnings are less vulnerable to changes in interest rates. We will now

look at each of these strategies in a more detailed fashion.

Spread Management

This focuses on maintaining an adequate spread between a bank’s interest rate

exposure on liabilities and its interest rate income on assets to ensure an acceptable

profit margin regardless of interest rate fluctuations. Thus spread management aims to

reduce the bank’s exposure to cyclical rates and to stabilize earnings over the long

term and in order to achieve this banks must manage the maturity, rate structure and

risks in its portfolios so that assets and liabilities are more or less affected equally by

interest rate cycles.

Maturities on assets and liabilities are either matched or unmatched. If they are

matched then the bank knows what it must pay for deposits and borrowed funds and

what it will earn on loans and investments. If maturities are unmatched then assets

and liabilities will mature at different times and in this case management cannot lock

in a spread because funds must be reinvested as assets mature and funds must be

borrowed as liabilities mature at rates that may differ from current market rates.

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Co-ordinating rate structure among assets and liabilities is a second most important

aspect of spread management because rate structure and maturity combined determine

interest sensitivity in assets and liabilities. For rate structure, the rates paid and earned

on fixed- rate assets and liabilities are not sensitive to changes in market rates because

their rates are fixed for the term of the instrument’s maturity. Variable rate assets and

liabilities are interest sensitive because their earnings fluctuate with changing market

conditions.

Risk of default is the third aspect of assets and liabilities that must be coordinated in

spread management. A bank assumes greater risk of default in its asset portfolios than

it can in its liability portfolios since the depositor’s funds need to be protected.

Therefore balancing the default risk against the benefit of probable returns by

assuming some risk to maintain a profitable spread is vital.Because it is difficult to

forecast future rate and yield changes accurately, many banks try to match their rate

sensitive assets to their rate sensitive liabilities. This approach will lead to controlled

but steady growth and a gradual increase in average profitability.

Gap Management

Gap management is based on the following rate mix classifications:

Variable: Interest bearing assets and liabilities whose rates fluctuate with general

money market conditions.

Fixed: Interest bearing assets and liabilities with a relatively fixed rate over an

extended period of time.

Matched: Specific sources and uses of funds in equal amounts that have

predetermined maturities.

By definition, gap is the amount by which the rate sensitive assets exceed the rate

sensitive liabilities. The gap indicates the dollar amount of funds available to fund the

variable rate assets with variable rate liabilities. Gap measurement allows the

management to evaluate the impact the various interest rate changes will have on

earnings.

The objective of gap management is to identify fund imbalances. For example, If rates

are declining and the banks have an excess of variable rate assets over fixed rate

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liabilities the bank’s rate will narrow and interest rate margin will be reduced. On the

other hand if rates are increasing and variable rate assets exceed fixed rate liabilities

the bank’s rate will widen and interest margin will increase.

The gap is really a measurement of the bank’s balance sheet sensitivity to changes in

the interest rates ,expressed as a ratio of the rate sensitive assets to rate sensitive

liabilities. The greatest stability occurs when rate sensitive assets equal rate sensitive

liabilities or a ratio of 1

In general, with this ratio the bank’s earnings should remain the same

regardless of the interest rate changes because equal amount of assets and liabilities

will be reprised.

Then the sensitivity ratio is greater than 1, the bank has a positive gap, or is asset

sensitive. This position is illustrated by the second gap in exhibit. If interest rates rise,

the bank will benefit as more assets than liabilities are reprised at higher rates.

Conversely, if rates fall the bank’s margin will be negatively affected as more assets

than liabilities will be reprised at lower rates.

When the sensitivity ratio is less than 1, the bank has a negative gap or is

liability sensitive. This position is illustrated in the figure’s final gap illustration. If

interest rates fall the bank will be benefited as more assets than liabilities will be

reprised at lower rates. Conversely, if interest rates rise the bank’s margin will be

negatively affected as more assets than liabilities will be reprised at lower rates. The

impact on earnings from a rate change with a particular sensitivity position are

generalizations and that a change in asset/liability mix and interest spread may affect

the bank’s margin either positively or negatively, regardless of the gap position and

the change in interest rates.

For example, assume that the bank is in matched position holding variable rate assets

(90 day prime rate loans) and variable rate liabilities (90 day CDs) with an interest

spread of 2%. Now assume that the general level of rates rise by 1%. But because

business credit demand is up, banks are borrowing more money to finance loan

growth. Due to this the CD rates have risen to 9.5% thereby reducing the interest

spread to 1.5%. Although the bank is in matched position and identical amounts of

assets and liabilities are reprised the interest-spread narrows resulting in lower

earnings.

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In gap management, the absolute size of the gap must be controlled to optimize the

fixed and variable asset/liability relationships throughout a complete interest rate

cycle. Similarly stated, the gap position must be managed to expand and contract with

rate cycle phases.

INTEREST SENSITIVITY ANALYSIS

There are certain asset and liability whose interest costs vary with interest

rate changes over some time horizon are referred to as Rate Sensitive Assets

(RSA) or RateSensitive Liabilities (RSL). Those assets or liabilities whose

interest costs do not vary with interest rate changes over some time horizon are

referred to as Non Rate Sensitive Assets (NRSA) or Non Rate Sensitive Liabilities

(RSL). It is very important to note that the critical factor in the classification of

time horizon chosen. An asset or liability that is time sensitive in a certain time

horizon may not be sensitive in shorter time horizon and vice versa. However,

over a significantly long time horizon, virtually all assets and liabilities are

interest rate sensitive. As the time horizon is shortened, the rate of rate sensitive to

non rate sensitive assets and liabilities falls.

The table below shows the classification of the assets and liabilities of the bank

according to their interest rate sensitivity.

LLiabilities Type Assets Type

DDemand Deposits NRSL Cash N RSA

CCurrent Accounts NRSL Short Term Securities RSA

Money Market Deposits RSL Long Term Securities N RSA

Short Term Deposits RSL Variable Rate Loans RSA

Short Term Savings NRSL Short Term Loans RSA

RRepo Transactions RSL Long Term Loans N RSA

E Equity NRSL Other Assets N RSA

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This is an extension of gap management. It attempts to improve the interest

spread by testing the effects of changes in rates, volume, and mix of assets and

liabilities given alternative movements in interest rates. In this analysis, the bank

plans from a given point in time and

projects possible changes in its income statement that might result if changes are

made in the balance sheet. Such changes are then tested against scenarios of rising

rates and falling rates for periods ranging from two weeks to one year.

The analysis begins by separating the bank’s balance sheet into fixed rate and

variable rate components. The interest rate and margin are identified in the current

year. The next step lists the various assumptions that involve the rate, mix, and

volume of the bank’s portfolios- for example, projected increases in the volume of

loans, consumer time deposits, and larger CD’s, as well the current rates on these

instruments. The remaining key assumptions reflect the possible alternative directions

in which the rates may move. The bank then tests the effect of assumed changes in the

volume and composition of its portfolios against both interest rate scenarios (rising

and falling rates) to determine their impact on interest spread and margin.

However if the bank’s assets and liabilities are unmatched, the bank’s earnings can be

protected or improved by planning courses of action in advance for periods of rising

and falling rates.

Hedging with futures trading is a final strategy that can be used to protect against

exposure to interest rate risk if the bank’s interest sensitive assets and liabilities are

unmatched. Banks can use futures contracts as tools of ALM by selling futures ( a

short hedge) or buying futures (a long hedge). If the bank is in an unmatched position

in which the interest sensitive assets are funded by fixed rate liabilities, it makes a

long hedge. If the position is one of fixed rate assets funded by interest sensitive

liabilities the bank makes a short hedge. The ability to use hedging effectively to

offset risk in an unmatched position require that the future course of interest rate

levels be predicted accurately.

Liquidity (or Marketability) :

It is the ease with which you can turn your investment quickly into cash, at or near the

current market price. Some securities, such as mutual funds, offer liquidity by

24

allowing investors to redeem their securities (return them to the issuer) on short

notice. For non-redeemable securities, liquidity will depend on the owner's ability to

sell the securities to other investors in the open market. Listing on a stock exchange

may help, but does not guarantee liquidity. With some securities, law or contract from

reselling the securities for months or even years may restrict investors, or they may

find that there is no market for the securities when they want to sell.

Liquidity risk management techniques are constantly evolving. Customers today

increasingly use banks as a means to access the payments system and, consequently,

maintain minimal transaction balances. This has resulted in a situation where all

banks are facing high loan demand while their core deposits continue to erode. Most

multinational and regional banks turned to wholesale funding sources to fund asset

growth years ago; we are now seeing small banks being forced to turn to alternative

funding sources, such as subordinated debt, Government Home Loan, Bank loans, and

purchased fed funds to meet their needs.

Liquidity Risk

Liquidity risk is the potential that an institution will be unable to meet its obligations

as they come due. This is generally because the bank cannot liquidate assets or obtain

adequate funding (funding liquidity risk) or that it cannot easily unwind or offset large

exposures without significantly lowering market prices because of thinly traded

securities markets or market disruptions (market liquidity risk). While the following is

not all inclusive, it does present several criteria can serve as a guide to determine the

level of inherent liquidity risk in an institution: The composition, size, and availability

of asset-based liquidity sources in relation to the institution’s liquidity structure and

liquidity needs should be gauged. Factors to consider include the levels of money

market assets (Eurodollar placements, Govt funds, etc.); unpledged, marketable

securities; and securitization and asset sales activities. Thus, a bank that utilizes

predominantly short-term liabilities for funding will generally require more asset-

based liquidity. Conversely, a bank utilizing predominantly long-term liabilities, such

as core deposits, for funding generally will require lower asset-based liquidity. The

nature, volatility, and maturity structure of funding liabilities given the institution’s

core business (for example, whether it is predominantly a wholesale bank) must be

25

considered. Factors to review include level of dependence on credit sensitive funding

sources, the relationship of wholesale versus retail funding sources, and large funding

concentrations, both by type of instrument and by funding source. Bank management

must make sure that the liability structure makes sense given the nature of the assets

generated by the core business. Community banks are predominantly retail banks

characterized by long-term asset structures supported by a stable and long-term

liability structure. Conversely, a wholesale bank is characterized by a short-term asset

structure supported by a short-term liability structure. This arrangement is considered

adequate, since the asset and liability roll-off are closely matched. Funding

diversification is extremely important in determining the level of inherent liquidity

risk in an institution. Factors to assess include:

The proportion of funding from various types of relationships, such as

brokers,

professional money managers, out of market sources, and foreign.

Sources of funds providers, for possible over-reliance on specific types of

funds

providers, funding instruments, and maturities.

The portion of funding sources with common exposures. Bankers should look

at their

funds providers to ensure that they do not have common exposures.

Many bankers have learned the hard way over the years that their funds providers

were not as diversified as they thought. It is entirely possible to utilize funds providers

located all over the country that have a common exposure in such areas as sub prime

lending or real estate. Deterioration in these areas of concentration can result in an

unexpected drying up of funding from traditional providers, which can cause large-

scale funding problems. Funding gap assessment is very important, especially the

institution’s short-term exposures. Factors to assess include projected funding needs,

assessment of bank’s ability to cover any potential funding gaps at reasonable pricing,

and trends in asset quality. All funding analysis techniques assume that assets pay

when due. Banks experiencing asset quality problems must revise their funding

analysis to embody a more realistic set of assumptions about asset roll- off. The

composition of the off-balance sheet portfolio and its probable impact on funding

26

must be evaluated. Factors that must be assessed include off-balance sheet liability

levels, composition of the off-balance sheet liabilities, and the off-balance sheet

monitoring program. The institution’s funding strategies should be evaluated to

ensure that they remain valid.

Factors to consider include cash flows, secondary liquidity of the securities portfolio,

monitoring and metrics program, policies and procedures, an assessment of

institutional funding costs compared to its competitors, and an assessment of

management’s ability to effectively control liquidity risk

A factor that is increasingly important is the rating services view of the institution.

The two factors to assess are current ratings and rating agency perspective on the

condition of the institution and rating trends. A detailed assessment of the institution’s

contingency funding program should be made.

Factors to evaluate include the monitoring and metrics program, a viability

assessment of the contingency plan in light of the abilities of management, an

assessment of policy and strategic goals, and a review of the structure and

responsibilities of the crisis management team.

LIQUIDITY RISK MANAGEMENT

Liquidity risk management techniques must continue to improve in response to the

increasing volatility of these funding sources. Managers who fail to develop an

effective strategy for maintaining adequate liquidity may find that, at best, their

business plans are adversely affected by funding difficulties, and at worst, their bank’s

ongoing viability is threatened. Recent volatility in the wholesale funding markets has

highlighted both the importance of sound liquidity risk management practices and the

fact that financial institutions can and have experienced liquidity problems even

during good economic times. As a result, bank management’s ability to adequately

meet daily and emergency liquidity needs while controlling liquidity risk through risk

identification, monitoring, and controls is receiving increasingly intense regulatory

scrutiny. To meet the new demands of liquidity risk management, banks have evolved

new techniques.

27

TRENDS IN LIQUIDITY RISK MANAGEMENT

Funding pools

Many multinational banks are moving away from back up lines of credit as their

principle source of liquidity in a funding crisis. Disadvantages to lines of credit

28

include commitment fee costs, material adverse change clauses, and a potentially

adverse reaction by the funding markets should these backup lines be utilized.

While many banks still maintain these lines, they no longer rely on them as their

principle source of back up liquidity (merely to meet the rating agencies’

requirements). These banks now rely principally on segregated pools of liquid assets,

generally, marketable securities, to provide a secondary source of liquidity. To be

effective, these segregated pools, sometimes known as liquidity warehouses, should

contain readily marketable securities. Two keys to making this approach work include

are to fill them with investment grade securities to preclude the possibility that they

could not be readily sold in adverse markets and to avoid the use of securities from

thinly traded markets that could preclude rapid liquidation without incurring a

substantial discount.

Funding strategies

Banks are revising their funding strategies to avoid funding concentrations. Most

banking experts agree that excessive funding concentrations severely reduce the

bank’s ability to survive a liquidity crisis. Many banks are taking advantage of the

good economic times to diversify their funding sources. While most banks have

developed a contingency funding plan, the vast majority require some level of

enhancement, including triggering guidelines, metrics development, better

quantification of funding sources, adequacy of projected funding sources, and

development of common contingency scenarios. Many banks do not have predefined

triggers to automatically implement their contingency plan, and management should

develop critical warning signals that would be used as a benchmark during periodic

liquidity reviews. In some cases, banks increasingly are stress testing their funding

plans, using various interest rate shocks and adverse economic and competitive

scenarios to ascertain their impact on both the funding portfolio and

market access. At a minimum, the funding plans are generally tested with an interest

rate shock simulation incorporating a drop or gain of at least 200 basis points. On the

horizon, banks are seeking ways to link their liquidity risk models with their market

risk models. The goal is to stress test their portfolios, load the resulting data into their

liquidity models, and see what will happen to their funding positions.

29

Communication

Some banks are working to improve the communication lines between the treasury

function and back-office operational areas. At present, the treasury area relies on

informal lines of communication to keep it updated on operational events that could

affect funding. As a result, the treasury area is frequently unaware of a disruptive

event, such as a wire transfer failure or the need to fund a large loan commitment

draw down, until it is either too late or very costly to cover the resulting funding

shortfall. Bank management is paying more attention to investor relations than ever

before. This is because dependence on wholesale funding sources has resulted in the

growing importance of credit risk in the placement decisions of funds providers.

Funds providers are increasingly sensitive to credit risk and will terminate a funding

relationship at the slightest hint of developing credit problems at an institution. This

has forced institutions to increase their attention to managing both funding

relationships and rating agency relations.

Reporting systems

Reporting systems are not as effective as they could be in determining the funding

implications of off-balance sheet commitments. Many banks perform a historical

survey and then develop a guideline for a level of funding to be held against off-

balance sheet commitments. Unfortunately, they seldom, it ever look at the guideline

again. As the bank’s strategic objectives change and new products are offered, the

level of off-balance sheet liabilities tends to grow while the level of funding does not,

since the bank’s reporting process is not measuring the true level of liabilities. This

lack of review, coupled with the informal lines of communication between treasury

and the operating areas of the bank, has frequently resulted in costly funding

mistakes. Many banks have realized this and are developing better off-balance sheet

reporting systems. In addition, many institutions have a tendency to ratchet down their

report generation during good economic times,

either reducing the level of information contained in the report or discontinuing some

reports altogether. This practice appears acceptable as long as the remaining reports

provide management with adequate information to properly manage risk. Banks

should realize, however, that to manage liquidity risk during adverse economic

conditions, a greater information flow embodying greater detail would be needed.

30

Therefore, policies should be in place to ratchet up the reporting process during

periods of deteriorating conditions.

TECHNIQUES OF ALM

1.GAP Analysis Model: Under the Gap analysis method, the various assets and

liabilities are grouped under various time buckets based on the residual maturity of

each item or the next repricing date, if on floating rate, whichever is earlier. Then the

gap between the assets and liabilities under each time bucket is worked out. Since the

objective is to maximize the NIT, it will be sufficient if this is done only with respect

to rate sensitive assets and liabilities. If the rate sensitive assets equal the rate

31

sensitive liabilities, it is known as the Zero Gap or matched book position. If the rate

sensitive assets are more than the rate sensitive liabilities, it is referred to as positive

gap position and if the rate sensitive assets are less than the rate sensitive liabilities, it

is known as negative gap position. The decision to hold a positive gap or a negative

will depend on the expectation on the movement of interest rates. The effect of an

upward movement or a downward movement in the interest rate on the Nil will also

depend on the position taken.

These effects are given in the table below:

GAP

Position

Changes in

Interest

Rates

Changes in

Interest

Income

Changes in

Interest

Expense

Change in

N I I

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

Positive gap indicates a bank has more sensitive assets than liabilities and the

NII will generally rise (fall) when interest rate rises (fall)

Negative gap indicates a bank has more sensitive liabilities than assets and the

NII will generally fall (rise) when interest rates rise (fall)

It measures the direction and extent of asset-liability mismatch through either

funding or maturity gap. It is computed for assets and liabilities of differing

32

maturities and is calculated for a set time horizon. This model looks at the reprising

gap that exists between the interest revenue earned and the bank's assets and the

interest paid on its liabilities over a particular period of time. It is sometimes referred

to as periodic gap because banks use gap analysis report to measure the interest rate

sensitivity of RSA and RSL for different periods. These periods are known as

maturity buckets which vary across banks, depending on the operating strategy.

Positive Gap Negative Gap

Rate Sensitive Assets are more than Rate

Sensitive Liabilities

Rate Sensitive Liabilities are more

than Rate Sensitive Assets

Assets mature before Liabilities Liabilities mature before Assets

Short-term assets funded with long-

term liabilities

Long-term assets funded with short-

term liabilities

If interest rate increase, NII also

Increase

If interest rate increase, NII also

Decrease

Assumptions

Contractual Repayment Schedule i.e. no early repayment or option like

feature

On Schedule Payments i.e. there is no early repayments or defaults

Advantages

Simple to analyze

Easy to implement

Helps in future analysis of Interest Rate Risk

Helps in projecting the NII for further analysis

33

Limitations

It does not incorporate future growth or changes in the mix of assets and

liabilities.

It in not take time value of money or initial net worth into account.

The periods used in the analysis are arbitrary and reprising is assumed to

occur at the midpoint of the period.

It does not provide a single reliable index of interest rate.

2.Duration Analysis: The Gap method ignores time value of money. Under the

duration method, the effect of a change in the interest rate on Nil is studied by

working out the duration gap and not the gap based on residual maturity.

a. Timing and the magnitude of the cash flows is ascertained and calculated

b. By using appropriate discounting factor, the present value of each of the cash

flows needs to be worked out.

c. The time weighted value of the present value of the cash flows is calculates.

d. The sum of the time weighted value of the cash flows divided by the sum

of the present values will give the duration of a particular asset.

Duration analysis is useful in assessing the impact of the interest rate changes on

the market

value of equity i.e. asset-liability structure.

DGAP

Position

Changes in

Interest

Change in Market value

Assets Liabilities Equity

Positive Increase Decrease Decrease Decrease

Positive Decrease Increase Increase Increase

Negative Increase Decrease Decrease Increase

Negative Decrease Increase Increase Decrease

Zero Increase Decrease Decrease None

Zero Decrease Increase Increase None

Advantages

34

Duration Gap analysis serves as a strategic tool for evaluating and

controlling interest rate risk.

It improves the maturity gap and cumulative gap models by taking into

account the timing and market value of cash flows rather them time

maturity.

It offers flexibility in spread management.

Instead of changing the maturity structure of assets and liabilities,

Duration Gap analysis puts emphasis on change of mix of assets or

liabilities whichever is feasible.

Limitations

It requires extensive data on specific characteristics and current market

pricing schedules of financial instruments.

It requires high degree of analytical expertise regarding issues such as term

structure of interest rates and yield curve dynamics.

Simulation Analysis : It analyzes the interest-rate risk arising from both current

and planned business. Gap analysis and duration analysis as standalone tool for

asset-liability management suffer from their inability to move beyond the static

analysis of current interest rate risk exposures. Basically simulation models

utilize computer power to provide what if scenarios.

What if:

The absolute level of interest rate shift

There are non parallel yield curve changes

Marketing plans are under-or-over achieved

Margins achieved in the past are not sustained/improved

Bad Debts and prepayment levels change in the different interest rate

scenarios

There are changes in the funding mix e.g. an increasing reliance on short-

term funds for balance sheet growth.

35

Accurate evaluation of current exposures of asset and liability portfolios to

interest rate risk.

Changes in multiple target variables such as NII, Capital adequacy and

liquidity.

There are certain criteria for the simulation model to succeed. These pertain to

accuracy of data and reliability of the assumptions made. In other words, one

should be in a position to look at alternatives pertaining to prices, growth rates,

reinvestments, etc., under various interest rate scenarios. This could be difficult

and sometimes contentious. it is also to be noted that the managers might not want

to document their assumptions and data is not easily

available for differential impacts of interest rates on several variables. Hence,

simulation models need to be used with the caution. The use of simulation model

calls for commitment of substantial amount of time and resources.

Assumptions

Expected changes and the levels of interest rates and the shape of yield curve

Pricing strategies for assets and liabilities

The growth, volume and mix of assets and liabilities

Advantages

It is easy to approximate very complex and discounted payoff

It is very flexible

It can incorporate multiple time periods

It captures majority of the option risk

Limitations

It is computationally intensive

36

It requires maintenance of pricing models

Value at Risk (VAR) Model: Under VAR credit rating is given to each of the

borrowers and its migration over the years form a part of the calculation of the

credit value at risk over a given time horizon. This is due to credit risk, which

emanates not only from counter party default, but also from slippage in credit

quality. Thus, the volatility of value due to changes in the quality of the credit

needs to be estimated to calculate VAR. In general; banks review financial

statements of borrowers once a year and allot credit ratings. But there is no

explicit theory to guide time horizon on risk assessment. Any risk assessment

model shall normally

predict relative risk than absolute risk. The objective of any risk assessment model

is to initiate risk mitigating actions, irrespective of the time horizons. Hence, any

risk measurement model can be tailored to suit different time horizons based on

actual need.

Advantages

Translates portfolio exposures into potential profit and loss

Aggregates and reports multi-product, multi-market exposures into one

number

Uses risk factors and correlations to create a risk weighted index

Monitors VAR limits

Meets external risk management disclosures and expectations.

Limitations

This study is useful only for normal operative accounts to predict their

probability of default.

This model does not take already defaulted customers into account.

Macro level changes in an industry, changes in government policies, etc.,

may result in distorted results.

In this methodology if the VAR measurement is for shorter duration, the

risk assessment is more accurate.

37

ROLE OF ALCO

The Asset-Liability Committee (ALCO) consisting of the bank's senior management

including CEO should be responsible for ensuring adherence to the limits set by the

Board as well as for deciding the business strategy of the bank (on the assets and

liabilities sides) in line with the bank's budget and decided risk management

objectives.

The ALM desk consisting of operating staff should be responsible for analyzing,

monitoring and reporting the risk profiles to the ALCO. The staff should also prepare

forecasts (simulations) showing the effects of various possible changes in market

38

conditions related to the balance sheet and recommend the action needed to adhere to

bank's internal limits.

The ALCO is a decision making unit responsible for balance sheet planning

from risk-return perspective including the strategic management of interest rate and

liquidity risks. Each bank will have to decide on the role of its ALCO, its

responsibility as also the decisions to be taken by it. The business and risk

management strategy of the bank should ensure that the bank operates within the

limits/parameters set by the Board. The business issues that an ALCO would consider,

inter alia, will include product pricing for both deposits and advances, desired

maturity profile of the incremental assets and liabilities, etc. In addition to monitoring

the risk levels of the bank, the ALCO should review the results of and progress in

implementation of the decisions made in the previous meetings. The ALCO would

also articulate the current interest rate view of the bank and base its decisions for

future business strategy on this view. In respect of the funding policy, for instance, its

responsibility would be to decide on source and mix of liabilities or sale of assets.

Towards this end, it will have to develop a view on future direction of interest rate

movements and decide on a funding mix between fixed vs floating rate funds,

wholesale vs retail deposits, money market v/s capital market funding, domestic vs

foreign currency funding, etc. Individual banks will have to decide the frequency for

holding their ALCO meetings.

Top Management, the CEO/CMD or ED should head the Committee. The

Chiefs of Investment, Credit, Funds Management/Treasury (forex and domestic),

International banking and Economic Research can be members of the Committee. In

addition the Head of Information

Technology Division should also be an invitee for building up of MIS and related

computerization. Some banks may even have sub-committees.

The size (number of members) of ALCO would depend on the size of each institution,

business mix and organizational complexity.

Committee composition

Permanent members:

Chairman Treasury Manager

39

Managing Director/CEO ALCO officerFinancial Director Divisional ManagersRisk Manager

By invitation:

Economist

Risk Consultants

Purposes and Tasks of ALCO:

Formation of an optimal structure of the Bank's balance sheet to provide

the maximum profitability, limiting the possible risk level;

Control over the capital adequacy and risk diversification;

Execution of the uniform interest policy

Determination of the Bank's liquidity management policy;

Control over the state of the current liquidity ratio and resources of the

Bank;

Formation of the Bank's capital markets policy;

Control over dynamics of size and yield of trading transactions

(purchase/sale of currency, state and corporate securities, shares,

derivatives for such instruments) as well as extent of diversification

thereof;

Control over dynamics of the basic performance indicators (ROE, ROA,

etc.) as prescribed in the Bank's policy.

PROCESS OF ALCO

40

H Meet monthly weekly and determine if current strategy is appropriate

H Meet monthly weekly and determine if current strategy is appropriate

ReviewPrevious month

result

ReviewPrevious month

result Access current Balance sheet options

Access current Balance sheet options

Project Exogenous factors

Project Exogenous factors

Develop asset liability strategies

Develop asset liability strategies

Stimulate asset liability strategies

Stimulate asset liability strategies

Determine most appropriate strategy

Determine most appropriate strategy

Set measurable targets

Set measurable targets

Communicate targets to appropriate manager

Communicate targets to appropriate manager

Monitor action regularly and evaluate

Monitor action regularly and evaluate

Organization Structure Of ALCO

41

Board of Director

Management Committee

Asset liability committee(ALCO)

Asset liability management cell

Financial planning department

Credit risk managementDepartment

Credit analysis department

Treasury

Investment and loan department

Trend analysis of Asset and liability component of Public sector,

Private sector and Foreign banks

Public Sector

2010 2011 2012 2013 2014

Asset accounts

Liquid asset 9.98% 9.94% 9.255% 9.215% 8.365%

investments 28.535% 27.16% 28.07% 28.12% 26.345%

Advances 57.995% 59.385% 59.39% 60.2% 62.275%

Fixed asset 0.97% 1.105% 1.08% 0.9% 0.785%

other asset 2.65% 2.41% 2.18% 1.89% 2.17%

Liability account

Capital 0.98% 0.775% 0.67% 0.52% 0.645%

Reserves 4.685% 4.725% 4.705% 4.595% 4.93%

Deposits 84.07% 84.13% 85.475% 86.035% 85.365%

Borrowings 3.88% 4.2% 3.225% 5.635% 6.08%

Other liability 6.385% 6.15% 5.91% 3.19% 2.8%

Private Sector

2010 2011 2012 2013 2014

Asset accounts

Liquid asset 13.715

%

13.77

%

12.245

%

10.59

%

10.5%

Investments 27.94% 27.06

%

28.895

%

30.79

%

29.33

%

Advances 53.01% 55.03

%

54.63% 55.61

%

55.63

%

Fixed asset 1.26% 1.32% 1.24% 1.23% 1.09%

other asset 3.03% 2.82% 2.99% 1.78% 2.53%

42

Liability

account

Capital 1.93% 1.67% 1.54% 1.55% 1.51%

Reserves 5.495% 7.21% 6.97% 7.45% 7.99%

Deposits 81.68% 81.41

%

81.3% 80.86

%

79.98

%

Borrowings 4.18% 3.42% 4.44% 5.7% 6.31%

Other liability 6.68% 6.29% 5.75% 4.44% 3.73%

Foreign Bank

2010 2011 2012 2013 2014

Asset accounts

Liquid asset 27.12

%

23.57

%

25.83

%

24.7% 23.45%

Investments 26.5% 26.75

%

25.65

%

31.79

%

30.37%

Advances 35.16

%

37.44

%

36.66

%

32.92

%

34.95%

Fixed asset 1.21% 0.93% 1.22% 1.032

%

1.82%

other asset 10% 11.5% 11.18

%

9.45% 9.43%

Liability

account

Capital 19.57

%

19.5% 25.67

%

24.07

%

28.55%

Reserves 7.74% 7.11% 7.58% 7.62% 7.93%

Deposits 44.91

%

44.87

%

42.41

%

41.54

%

36.088

%

Borrowings 20.58 20.71 17.31 19.94 20.54%

43

% % % %

Other liability 7.3% 7.12% 6.99% 6.49% 6.3%

44

TREND OF ASSET COMPONENTS IN PUBLIC

SECTOR:

45

46

TREND OF LIABILITY COMPONENTS IN PUBLIC

SECTOR:

47

TREND OF ASSET COMPONENTS IN PRIVATE

SECTOR:

48

49

50

TREND OF LIABILITY COMPONENTS IN PRIVATE

SECTOR:

51

52

TREND OF ASSET COMPONENTS IN FOREIGN

BANKS:

53

54

TREND OF LIABILITY COMPONENTS IN FOREIGN

BANKS:

55

Public/Private bank Foreign bank

56

Comparison of asset liability components of

Public/Private banks and foreign banks:

Asset accounts Public/Private bank Foreign bank

Liquidity of assets Less more

Investment Difference No significant difference

Advances More Less

Fixed assets Difference No significant difference

Other assets Less More

Liability accountsPublic/Private bank Foreign bank

Capital Less More

Reserves Difference No significant difference

Deposits More Less

Borrowings Less More

Others Not significant Significant

Liabilities Difference No significant difference

Each of the asset and liability accounts defined have different trend over time,

showing the impact of change of prudential regulations of RBI, enhancement of

technology, global integration, liberalization ,etc.

As u can see In case of public sector banks and private sector banks, major item on

liability side is deposits ,and on asset side are advances. These accounts have around

80 per cent share in total assets/liabilities. While in case of foreign banks major items

on asset side are Liquid assets, Other assets and on liability side Capital and

borrowings. In case of public sector banks and private sector banks the share of liquid

asset accounts including cash, balances with RBI and banks, and money at call and

short notice declined over time. while in case of foreign banks liquid assets are more

and almost constant over period of time.

Bank's capital, is the margin by which creditors are covered if the bank's assets

were liquidated. Capital serves as a cushion for depositors and creditors, and

57

considered as a long-term source for bank. In case of public sector banks and private

sector banks ratio of capital to total assets, i.e. share of capital in total liabilities

declined, whereas the share of ratio of reserves and surplus to total assets increased.

Foreign banks have higher proportion of capital, reserves, borrowings and liquid asset

as compared to public and private sector banks. High share of equity may be due to

higher regulatory capital. Public sector banks have highest share in deposits than other

bank groups. This may be due to the foundation structure of public sectors banks.

58

Findings & conclusion:

Asset liability management is an integral part of financial management process

of any bank. It is concerned with strategic balance sheet management involving risk

caused by changes in the interest rates, exchange rates and liquidity position of the

banks.It also focuses on managing credit risk , contingency risk .It can termed as risk

management technique design to earn an adequate return while maintaining a

comfortable surplus of assets beyond liabilities.

It takes into consideration interest rates, earning power and degree of willingness

to take on debt and is also known as Surplus Management .It is nothing but efficient

management of balance sheet dynamics with regard to its size, constituents and

quality. It is a process of managing Net Interest Margin(NIM) within the overall risk

bearing ability of banks.ALM process depends on understanding balance sheet ;the

availability, accuracy , adequacy and expediency of the data and the MIS system. In

simple words ALM is nothing but “An attempt to match asset and liability” in terms

of maturities and interest rates sensitivities and also to minimize Interest rates risk and

Liquidity risk.

From the name it’s clear that it has two parts Asset management and Liability

management

Asset Management is “ How liquid are the asset of the banks”.

Liability Management is “How easy the bank can generate loans from market”

There are certain risks involved in ALM like Interest rate risk: which focuses on

understanding negative impact on bank’s future earnings and market value due to

changes in interest rates.

Liquidity risk: It is risk of having inefficient liquid assets to meet liability at given

time.

59

Forex risk: It is risk of having losses in foreign exchange asset and liability due to

exchange in exchange rates among multi-currencies under consideration.

There are different types of strategies to manage different types of risks like for

interest rate risk there are various models like GAP analysis, Duration Gap analysis,

and value at risk. There are certain assets and liabilities which are interest sensitive

and some are non interest sensitive so depending on that NIM also changes. so there is

connection between this two. To manage this there is “Asset Liability Committee”.

This committee responsible for managing asset liability, forming various policies,

taking some important decision.

Asset liability composition of public sector banks, private sector banks is

different than foreign banks. Trend analysis had proved this hypothesis true. So

overall ALM is “Process of decision making to control risk of existence, stability and

growth of the system through the dynamic balances of its asset and liability.

60

BIBLIOGRAPHY:

www.rbi.com

www.iba.org.in

Research paper on Relationship between asset and liability of

Indian Commercial bank By Seema Jaiswal.

Book on Asset Liability Management 2nd Edition by T Ravi

Kumar

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