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Liability Management
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Acknowledgement
Also I would like to take this opportunity to thank all the staff of
N.L. Dalmia Institute of Management Studies and Research for
providing the necessary infrastructure and facilities for helping to
take the project to fruition.
Reshma Fernandes
Contents
Banks face several risks such as the liquidity risk, interest rate
risk, credit risk and operational risk. Asset Liability management
(ALM) is a strategic management tool to manage interest rate risk
and liquidity risk faced by banks, other financial services
companies and corporations.
Exhibit 1
ALM has evolved since the early 1980's. Today, financial firms are
increasingly using market-value accounting for certain business
lines. This is true of universal banks that have trading operations.
For trading books, techniques of market risk management—
value-at-risk (VaR), market risk limits, etc.—are more appropriate
than techniques of ALM. In financial firms, ALM is associated with
those assets and liabilities—those business lines—that are
accounted for on an accrual basis. This includes bank lending and
deposit taking. It includes essentially all traditional insurance
activities.
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.
Composition of ALCO:
Committee of Directors:
Bank’s Liabilities:
I) Capital
- Statutory Reserves
- Capital Reserves
- Investment Fluctuation Reserve
- Revenue and Other Reserves
- Balance in Profit and Loss Account
III) Deposits
- Demand Deposits
- Savings Bank Deposits
- Term Deposits
IV) Borrowings
Borrowings in India
It includes:
i) Bills Payable
ii) Inter Office Adjustments (Net)
iii)Interest Accrued
iv) Unsecured Redeemable Bonds (Subordinated Debt
for Tier-II Capital)
v) Others (including provisions)
VI) Contingent Liabilities
Bank’s Assets:
In India
a) In Current Accounts
b) In Other Deposit Accounts
a) With Banks
b) With Other Institutions
Outside India
a) In Current Accounts
III) Investments
i) Government Securities
ii) Other approved Securities
iii) Shares
iv) Debentures and Bonds
v) Subsidiaries and Sponsored Institutions
vi) Others (UTI Shares, Commercial Papers, COD & Mutual
Fund Units etc.)
IV) Advances
B. Particulars of Advances:
iii) Unsecured
V) Fixed Assets
I. Premises
- Interest accrued
- Tax paid in advance/tax deducted at source (Net of
Provisions)
- Stationery and Stamps
- Non-banking assets acquired in satisfaction of claims
- Deferred Tax Asset (Net)
- Others
3. Examine the credit risk and contingency risk that may originate
either due to rate fluctuations or otherwise and assess the quality
of assets.
Categories of Risk:
Credit risk:
This is not the full story. Since thousands of cases are pending in
the lower courts, legal experts suggest that the average time
Capital risk:
Capital Risk means the risk an investor faces that he or she may
lose all or part of the principal amount invested. It also means 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.
Market risk:
deposits differed from those for which they fixed on assets, banks
incurred interest rate risk i.e., they stood to make gains or losses
with every change in the level of interest rates. As long as
changes in rates were predictable both in magnitude and in
timing over the business cycle, interest rate risk was not seen as
too serious, but as rates of interest became more volatile, there
was felt need for explicit means of monitoring and controlling
interest gaps.
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:
Dollar duration:
Convexity:
Liquidity risk:
For example, through most of the term loans and cash credit
loans in banking system are at floating rate linked to internal PLR
of banks, the degree to which they respond to changes in
external benchmark rates is a matter of debate. Further, the
Currency Risk:
Presently, the banks are also free to set gap limits with RBI's
approval but are required to adopt Value at Risk (VaR) approach
to measure the risk associated with forward exposures. Thus the
open position limits together with the gap limits form the risk
management approach to Forex operations. For monitoring such
risks banks should follow the instructions contained in Circular
A.D (M. A. Series) No.52 dated December 27, 1997 issued by the
Exchange Control Department.
Basis Risk:
Price Risk:
Operational risk:
Reinvestment Risk:
The risk resulting from the fact that interest or dividends earned
from an investment may not be able to be reinvested in such a
way that they earn the same rate of return as the invested funds
that generated them. For example, falling interest rates may
prevent bond coupon payments from earning the same rate of
return as the original bond.
Maturity:
Coupon rate:
The higher the coupon rate, the larger the size of the cash flows
to be reinvested, and the bigger the reinvestment risk. Therefore
a zero-coupon bond has zero reinvestment risk if held to
maturity, and a premium bond has bigger reinvestment risk than
a discount bond.
NIIi = R i (GAPi)
While NII is the net interest income, R refers to the interest rates
impacting assets and liabilities in the relevant maturity bucket
and GAP refers to the differences between the book value of the
rate sensitive assets and the rate sensitive liabilities. Thus when
there is a change in the interest rate, one can easily identify the
impact of the change on the net interest income of the bank.
Interest rate changes have a market value effect. The basic
weakness with this model is that this method takes into account
only the book value of assets and liabilities and hence ignores
their market value. This method therefore is only a partial
measure of the true interest rate exposure of a bank.
Duration model:
DP p = D ( dR /1+R)
zero. The duration model has one important benefit. It uses the
market value of assets and liabilities.
Value at Risk:
VAR summarizes the predicted maximum loss (or worst loss) over
a target horizon within a given confidence level. The well-known
proprietary models that use VAR approaches are JP Morgan’s Risk
metrics, Banker’s trust Risk Adjusted Return on Capital, and
Chase’s Value at risk.
Simulation:
What if:
situation. Last but not the least, the use of simulation models
calls for commitment of substantial amount of time and
resources. If we cannot afford the cost or, more importantly the
time involved in simulation modeling, it makes sense to stick to
simpler types of analysis.
Rupees
Liability/Assets In Percentage
(In Cr)
Many of the new private sector banks and some of the non-
banking financial companies have gone in for complete
Conclusion:
Bibliography:
Websites:
www.wikipedia.com
www.google.com
www.businessworld.com
www.economictimes.com
Reference books: