REPORT On Asset Liability Management - Reshma - Fernandes

REPORT On Asset
Liability Management
Submitted By:
Reshma Fernandes (312)
PGDBM Finance (2007-09)
N.L.Dalmia Institute of Management Studies and Research

Asset – Liability Management
Certificate
This is to certify that Miss. Reshma Fernandes student of N.L.

Dalmia Institute of Management Studies & Research has
successfully carried out the project on “Asset – Liability
Management” under my supervision & guidance as partial
fulfillment of the requirements of PGDBM course, 2007-09.
Prof. V.S Date Prof. P.L.

Arya
(Project Guide) (Director,

NLDIMSR)
Acknowledgement
My special thanks to all the professors for imparting useful

information on the project. It gives me a sense of great pride to
acknowledge the fact that working on this project has added
value to my learning process.
N.L.Dalmia Institute of Management Studies and Research 2

I also extend my gratitude to Prof. Vinayak Date, our Course

Coordinator, for providing the necessary guidance and support,
during the preparation of the project.
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
(PGDBM Finance, 2007-09)
Contents
 Asset - Liability Management concept and its Emergence

 Asset - Liability Management in Banks
 Three requirements to implement ALM in Banks
 Components of Assets & Liabilities
 Purpose and Objectives of Asset - Liability Management
 Advantages of Asset - Liability Management
 Risk Categories
 Risk Measurement Techniques
 Pre - Conditions for the Success of ALM in Banks
 Asset - Liability Management Strategies for Correcting
Mismatch

 Information Technology and Asset - Liability Management in

the Indian context
 Emerging Issues in the Indian context
 Conclusion
 Bibliography
Asset - Liability Management concept and its

Emergence:
In banking, asset liability management is the practice of

managing risks that arise due to mismatches between the assets
and liabilities (debts and assets) of the bank.
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.
Banks manage the risks of Asset liability mismatch by matching

the assets and liabilities according to the maturity pattern or the
matching the duration, by hedging and by securitization. The
early origins of asset and liability management date to the high
interest rate periods of 1975-6 and the late 1970s and early
1980s in the United States.
Modern risk management now takes place from an integrated

approach to enterprise risk management that reflects the fact
that interest rate risk, credit risk, market risk, and liquidity risk
are all interrelated.
Asset-liability management (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. This article describes ALM as a

general concept, starting with more traditional usage.
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.
Consider a bank that borrows USD 100MM at 3.00% for a year

and lends the same money at 3.20% to a highly-rated borrower
for 5 years. For simplicity, assume interest rates are annually
compounded and all interest accumulates to the maturity of the
respective obligations. The net transaction appears profitable—
the bank is earning a 20 basis point spread—but it entails
considerable risk. At the end of a year, the bank will have to find
new financing for the loan, which will have 4 more years before it
matures. If interest rates have risen, the bank may have to pay a
higher rate of interest on the new financing than the fixed 3.20 it
is earning on its loan.
Suppose, at the end of a year, an applicable 4-year interest rate

is 6.00%. The bank is in serious trouble. It is going to be earning
3.20% on its loan and paying 6.00% on its financing. Accrual
accounting does not recognize the problem. The book value of
the loan (the bank's asset) is:
100MM (1.032) = 103.2MM.
The book value of the financing (the bank's liability) is:
100MM (1.030) = 103.0MM.
Based upon accrual accounting, the bank earned USD 200,000 in

the first year.
Market value accounting recognizes the bank's predicament. The

respective market values of the bank's asset and liability are:

100MM (1.030) = 103.0MM.
From a market-value accounting standpoint, the bank has lost

USD 10.28MM.
So which result offers a better portrayal of the bank's situation,

the accrual accounting profit or the market-value accounting
loss? The bank is in trouble, and the market-value loss reflects
this. Ultimately, accrual accounting will recognize a similar loss.
The bank will have to secure financing for the loan at the new
higher rate, so it will accrue the as-yet unrecognized loss over the
4 remaining years of the position.
The problem in this example was caused by a mismatch between

assets and liabilities. Prior to the 1970's, such mismatches tended
not to be a significant problem. Interest rates in developed
countries experienced only modest fluctuations, so losses due to
asset-liability mismatches were small or trivial. Many firms
intentionally mismatched their balance sheets. Because yield
curves were generally upward sloping, banks could earn a spread
by borrowing short and lending long.
Things started to change in the 1970s, which ushered in a period

of volatile interest rates that continued into the early 1980s. US
regulation, which had capped the interest rates that banks could
pay depositors, was abandoned to stem a migration overseas of
the market for USD deposits. Managers of many firms, who were
accustomed to thinking in terms of accrual accounting, were slow
to recognize the emerging risk. Some firms suffered staggering
losses. Because the firms used accrual accounting, the result was
not so much bankruptcies as crippled balance sheets. Firms
gradually accrued the losses over the subsequent 5 or 10 years.
One example is the US mutual life insurance company the

Equitable. During the early 1980s, the USD yield curve was
inverted, with short-term interest rates spiking into the high
teens. The Equitable sold a number of long-term guaranteed
interest contracts (GICs) guaranteeing rates of around 16% for
periods up to 10 years. During this period, GICs were routinely for

principal of USD 100MM or more. Equitable invested the assets

short-term to earn the high interest rates guaranteed on the
contracts. Short-term interest rates soon came down. When the
Equitable had to reinvest, it couldn't get nearly the interest rates
it was paying on the GICs. The firm was crippled. Eventually, it
had to demutualize and was acquired by the Axa Group.
Increasingly, managers of financial firms focused on asset-liability

risk. The problem was not that the value of assets might fall or
that the value of liabilities might rise. It was that capital might be
depleted by narrowing of the difference between assets and
liabilities—that the values of assets and liabilities might fail to
move in tandem. Asset-liability risk is a leveraged form of risk.
The capital of most financial institutions is small relative to the
firm's assets or liabilities, so small percentage changes in assets
or liabilities can translate into large percentage changes in
capital.
Exhibit 1 illustrates the evolution over time of a hypothetical

company's assets and liabilities. Over the period shown, the
assets and liabilities change only slightly, but those slight
changes dramatically reduce the company's capital (which, for
the purpose of this example, is defined as the difference between
assets and liabilities). In Exhibit 1, the capital falls by over 50%, a
development that would threaten almost any institution.
Example: Asset-Liability Risk
Exhibit 1
Asset-liability risk is leveraged by the fact that the values of

assets and liabilities each tend to be greater than the value of

capital. In this example, modest fluctuations in values of assets

and liabilities result in a 50% reduction in capital.
Accrual accounting could disguise the problem by deferring

losses into the future, but it could not solve the problem. Firms
responded by forming asset-liability management (ALM)
departments to assess asset-liability risk. They established ALM
committees comprised of senior managers to address the risk.
Techniques for assessing asset-liability risk came to include gap

analysis and duration analysis. These facilitated techniques of
gap management and duration matching of assets and liabilities.
Both approaches worked well if assets and liabilities comprised
fixed cash flows. Options, such as those embedded in mortgages
or callable debt, posed problems that gap analysis could not
address. Duration analysis could address these in theory, but
implementing sufficiently sophisticated duration measures was
problematic. Accordingly, banks and insurance companies also
performed scenario analysis.
With scenario analysis, several interest rate scenarios would be

specified for the next 5 or 10 years. These might specify declining
rates, rising rates, a gradual decrease in rates followed by a
sudden rise, etc. Scenarios might specify the behavior of the
entire yield curve, so there could be scenarios with flattening
yield curves, inverted yield curves, etc. Ten or twenty scenarios
might be specified in all.
Next, assumptions would be made about the performance of

assets and liabilities under each scenario. Assumptions might
include prepayment rates on mortgages or surrender rates on
insurance products. Assumptions might also be made about the
firm's performance—the rates at which new business would be
acquired for various products. Based upon these assumptions,
the performance of the firm's balance sheet could be projected
under each scenario. If projected performance was poor under
specific scenarios, the ALM committee might adjust assets or
liabilities to address the indicated exposure. A shortcoming of
scenario analysis is the fact that it is highly dependent on the
choice of scenarios. It also requires that many assumptions be
made about how specific assets or liabilities will perform under
specific scenarios.

In a sense, ALM was a substitute for market-value accounting in a

context of accrual accounting. It was a necessary substitute
because many of the assets and liabilities of financial institutions
could not—and still cannot—be marked to market. This spirit of
market-value accounting was not a complete solution. A firm can
earn significant mark-to-market profits but go bankrupt due to
inadequate cash flow. Some techniques of ALM—such as duration
analysis—do not address liquidity issues at all. Others are
compatible with cash-flow analysis. With minimal modification, a
gap analysis can be used for cash flow analysis. Scenario analysis
can easily be used to assess liquidity risk.
Firms recognized a potential for liquidity risks to be overlooked in

ALM analyses. They also recognized that many of the tools used
by ALM departments could easily be applied to assess liquidity
risk. Accordingly, the assessment and management of liquidity
risk became a second function of ALM departments and ALM
committees. Today, liquidity risk management is generally
considered a part of ALM.
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.
Techniques of ALM have also evolved. The growth of OTC

derivatives markets has facilitated a variety of hedging
strategies. A significant development has been securitization,
which allows firms to directly address asset-liability risk by
removing assets or liabilities from their balance sheets. This not
only eliminates asset-liability risk; it also frees up the balance
sheet for new business.
The scope of ALM activities has widened. Today, ALM

departments are addressing (non-trading) foreign exchange risks
and other risks. Also, ALM has extended to non-financial firms.

Corporations have adopted techniques of ALM to address

interest-rate exposures, liquidity risk and foreign exchange risk.
They are using related techniques to address commodities risks.
For example, airlines' hedging of fuel prices or manufacturers'
hedging of steel prices are often presented as ALM.
There are two types of ALM analysis:
Analytical: This includes liquidity and sensitivity gaps, sensitivity

and parametric Value at Risk analysis
Numerical: This includes stress scenario and Value at Risk (VaR)

analysis.
Asset - Liability Management in Banks:
Ever since the initiation of the process of deregulation of the

Indian banking system and gradual freeing of interest rates to
market forces, and consequent injection of a dose of competition
among the banks, introduction of asset-liability management
(ALM) in the public sector banks (PSBs) has been suggested by
several experts. But, initiatives in this respect on the part of most
bank managements have been absent. This seems to have led
the Reserve Bank of India to announce in its monetary and credit
policy of October 1997 that it would issue ALM guidelines to
banks. While the guidelines are awaited, an informal check with
several PSBs shows that none of these banks has moved
decisively to date to introduce ALM.

One reason for this neglect appears to be a wrong notion among

bankers that their banks already practice ALM. As per this
understanding, ALM is a system of matching cash inflows and
outflows, and thus of liquidity management. Hence, if a bank
meets its cash reserve ratio and statutory liquidity ratio
stipulations regularly without undue and frequent resort to
purchased funds, it can be said to have a satisfactory system of
managing liquidity risks, and, hence, of ALM.
The actual concept of ALM is however much wider, and of greater

importance to banks performance. Historically, ALM has evolved
from the early practice of managing liquidity on the bank's asset
side, to a later shift to the liability side, termed liability
management, to a still later realization of using both the assets
as well as liabilities sides of the balance sheet to achieve
optimum resources management. But that was till the 1970s.
In the 1980s, volatility of interest rates in USA and Europe caused

the focus to broaden to include the issue of interest rate risk. ALM
began to extend beyond the bank treasury to cover the loan and
deposit functions. The induction of credit risk into the issue of
determining adequacy of bank capital further enlarged the scope
of ALM in later 1980s.
In the current decade, earning a proper return of bank equity and

hence maximization of its market value has meant that ALM
covers the management of the entire balance sheet of a bank.
This implies that the bank managements are now expected to
target required profit levels and ensure minimization of risks to
acceptable levels to retain the interest of investors in their banks.
This also implies that costing and pricing policies have become of
paramount importance in banks.
In the regulated banking environment in India prior to the 1990s,

the equation of ALM to liquidity management by bankers could be
understood. There was no interest rate risk as the interest rates
were regulated and prescribed by the RBI. Spreads between the
deposit and lending rates were very wide (these still are
considerable); also, these spreads were more or less uniform
among the commercial banks and were changed only by RBI.

If a bank suffered significant losses in managing its banking

assets, the same were absorbed by the comfortably wide
spreads. Clearly, the bank balance sheet was not being managed
by banks themselves; it was being `managed' through
prescriptions of the regulatory authority and the government.
This situation has now changed. The banks have been given a
large amount of freedom to manage their balance sheets. But the
knowledge, new systems and organizational changes that are
called for to manage it, particularly the new banking risks, are
still lagging.
The turmoil in domestic and international markets during the last

few months and impending changes in the country's financial
system are a grim warning to our bank managements to gear up
their balance sheet management in a single heave. To begin with,
as the RBI's monetary and credit policy of October 1997
recommends, an adequate system of ALM to incorporate
comprehensive risk management should be introduced in the
PSBs. It is suggested that the PSBs should introduce ALM which
would focus on liquidity management, interest rate risk
management and spread management.
Three requirements to implement ALM in Banks:

(a) Developing a better understanding of ALM concepts
(b) Introducing an ALM information system
Information is the key to the ALM process. Considering the large

network of branches and the lack of an adequate system to
collect information required for ALM which analyses information
on the basis of residual maturity and behavioral pattern it will
take time for banks in the present state to get the requisite
information. The problem of ALM needs to be addressed by
following an ABC approach i.e. analyzing the behavior of asset
and liability products in the top branches accounting for
significant business and then making rational assumptions about
the way in which assets and liabilities would behave in other
branches. In respect of foreign exchange, investment portfolio
and money market operations, in view of the centralized nature
of the functions, it would be much easier to collect reliable
information. The data and assumptions can then be refined over
time as the bank management gain experience of conducting
business within an ALM framework. The spread of
computerization will also help banks in accessing data.
(c) Setting up ALM decision-making processes (ALM

Committee/ALCO)
The Board should have overall responsibility for management of

risks and should decide the risk management policy of the bank
and set limits for liquidity, interest rate, foreign exchange and
equity price risks.
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

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 vs capital market funding, domestic vs foreign
currency funding, etc. Individual banks will have to decide the
frequency for holding their ALCO meetings.
Composition of ALCO:
The size (number of members) of ALCO would depend on the size

of each institution, business mix and organizational complexity.
To ensure commitment of the 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 the Information
Technology Division should also be an invitee for building up of

MIS and related computerization. Some banks may even have

sub-committees.
Committee of Directors:
Banks should also constitute a professional Managerial and

Supervisory Committee consisting of three to four directors which
will oversee the implementation of the system and review its
functioning periodically.
The scope of ALM function can be described as follows:
 Liquidity risk management

 Management of market risks (including Interest Rate
Risk)
 Funding and capital planning
 Profit planning and growth projection
 Trading risk management
However the above mentioned three requirements to implement

ALM are already met by the new private sector banks, for
example. These banks have their balance sheets available at the
close of every day. Repeated changes in interest rates by them
during the last 3 months to manage interest rate risk and their
maturity mismatches are based on data provided by their MIS. In
contrast, loan and deposit pricing by PSBs is based partly on
hunches, partly on estimates of internal macro data, and partly
on their competitors' rates. Hence, PSBs would first and foremost
need to focus son putting in place an ALM which would provide
the necessary framework to define, measure, monitor, modify
and manage interest rate risk. This is the need of the hour.

Components of Assets & Liabilities in Banks Balance

Sheet and their Management:
Bank’s Liabilities:
The sources of funds for the lending and investment activities

constitute liabilities side of balance sheet i.e.
I) Capital
Capital represents owner’s contribution/stake in the bank.
- It serves as a cushion for depositors and creditors.

- It is considered to be a long term sources for the bank.
II) Reserves and Surplus
Components under this head include:
- Statutory Reserves
- Capital Reserves
- Investment Fluctuation Reserve
- Revenue and Other Reserves
- Balance in Profit and Loss Account
III) Deposits
This is the main source of bank’s funds. The deposits are

classified as deposits payable on ‘demand’ and ‘time’. They
are reflected in balance sheet as under:
- Demand Deposits
- Savings Bank Deposits
- Term Deposits

IV) Borrowings
It includes Refinance / Borrowings from RBI, Inter-bank & other

institutions
Borrowings in India
i) Reserve Bank of India

ii) Other Banks
iii) Other Institutions & Agencies
Borrowings outside India
V) Other Liabilities and Provisions
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 obligations under Letter of Credits, Guarantees, and

Acceptances on behalf of constituents and Bills accepted by
the bank are reflected under this heads.
Bank’s Assets:
The funds mobilized by bank through various sources are:
I) Cash and Bank balances with Reserve Bank of

India.
- Cash in hand (including foreign currency notes)

- Balances with Reserve Bank of India (In Current Accounts
and In Other Accounts)
II) Balances with banks and money at call and short

notice.

In India
Balances with Banks
a) In Current Accounts
b) In Other Deposit Accounts
Money at Call and Short Notice
a) With Banks
b) With Other Institutions
Outside India
a) In Current Accounts
b) In Other Deposit Accounts
c) Money at Call & Short Notice
III) Investments
It is a major asset item in the bank’s balance sheet. Reflected

under 6 buckets as under:
Investments in India in:
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.)
Investments outside India in:
Subsidiaries and/or Associates abroad
IV) Advances
A. i) Bills Purchased and Discounted

ii) Cash Credits, Overdrafts & Loans repayable on demand
iii) Term Loans
B. Particulars of Advances:
i) Secured by tangible assets (including advances against

Book Debts)
ii) Covered by Bank/ Government Guarantees
iii) Unsecured
V) Fixed Assets
I. Premises
II. Other Fixed Assets (Including furniture and fixtures)
VI) Other Assets.
- 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

Purpose and Objectives of Asset - Liability

Management:
1. Review the interest rate structure and compare the same to

the interest/product pricing of both assets and liabilities.
2. Examine the loan and investment portfolios in the light of the

foreign exchange risk and liquidity risk that might arise.
3. Examine the credit risk and contingency risk that may originate
either due to rate fluctuations or otherwise and assess the quality
of assets.
4. Reviews the actual performance against the projections made

and analyzes the reasons for any effect on spreads.
5. Aim is to stabilize the short-term profits, long-term earnings

and long-term substance of the bank. The parameters that are
selected for the purpose of stabilizing asset liability management
of banks are:
• Net Interest Income (NII)

• Net Interest Margin (NIM)
• Economic Equity Ratio
Net Interest Income = Interest Income - Interest Expenses.
Net Interest Margin = Net Interest Income/Average Total Assets
Economic Equity Ratio- The ratio of the shareholders funds to the

total assets measures the shifts in the ratio of owned funds to
total funds. The fact assesses the sustenance capacity of the
bank
Advantages of Asset - Liability Management:

Leverages the Powerful Cash Flow Engine to Enhance

Flexibility of Analysis:
The powerful Cash Flow Engine (CFE) of Asset Liability

Management application shreds accounts level data into its
constituent cash flows. Given the end of period balances and the
schedule terms, the CFE can generate multiple cash flows as
required for different analyses.
Enables Factual and Consistent Risk Measurement:
Asset Liability Management application supports both Earnings

and Economic Value perspectives in a single framework. Using a
single download of information from the source system along with
some set-up information, the Asset Liability Management
application generates all three AL perspectives – Liquidity,
Earnings, and Economic Value, thus ensuring factual and
consistent risk measurement. Analyses use the same data set,
ensuring consistency.
Facilitates Multi-Currency Analyses:
Asset Liability Management application tags individual accounts

with their respective currencies, enabling users to explore
mismatches across currencies, both time band wise and
cumulatively. The currency conversion engine works on the three-
currency framework through the natural, local, and reporting
currency.
Robust “What if” Engine Enables the Creation and

Evaluation of Multiple Scenarios:
Asset Liability Management application enables the risk

managers to simulate multiple scenarios to evaluate the potential
impact on the Balance Sheet due to possible changes in the key
drivers of business be it New Business Volumes, Interest Rates,
Currency Rates, or change in portfolio composition through
switches. Designed for ease-of-use, Asset Liability Management
application works off metadata and allows end-users to explore
scenarios by changing variables individually or in combinations
across product, branch, and benchmark dimensions.

Solution Design Helps Adopt Regulatory Frameworks:
Risk professionals need solutions that simplify adoption of, and

checking conformance to, regulatory norms. Asset Liability
Management application design has drawn from standards like
the Basel Norms (Principles of Interest rate risk in 2001).
An illustrative list of features includes:
• Supports both earnings and economic value perspectives
• CFE granularity enables:
a. Aggregation to any level
b. Computing of Cash Flow duration
• Enables Sensitivity Analysis – sensitivity of accrued interest,

interest flows, time weighted flows, etc.
• Interest Rate Shocking – both Standard and Percentile

approaches
• What-If Scenario analyses
Leverages Multi-dimensional Analyses:
ALM professionals of various roles need different views and

details of business situations. Asset Liability Management
application leverages multi-dimensional analyses to allow rapid
navigation through relevant data, and quickly provides multiple
internally consistent views of specific data sets, enabling a
deeper and quicker grasp of risk numbers. Illustrative dimensions
are Rate Sensitivity, Time, Time-Bands, Organization or Business
Unit, Currency, Interest Type, and Product.
Accurately Identifies Mismatches and Locates Risk

Concentrations:
Identifying mismatches and the risk concentration points that

lead to the mismatches is critical to risk management. Asset
Liability Management application enables the locating of
mismatches both On Balance Sheet and Off Balance Sheet, as

well as the identification of concentration points by drilling down

on business lines, product, and currency. Time dimension enables
trend analysis across time. All these capabilities facilitate a more
informed risk response.
Categories of Risk:
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. The recent
failure of many Japanese banks and failure of savings and loan
associations in the 1980s in the USA are important examples,
which provide lessons for others. It may be noted that the
willingness to pay, which is measured by the character of the
counter party, and the ability to pay need not necessarily go
together.
The other important issue is contract enforcement in countries

like India. 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. Over two million
cases are pending in 18 High Courts alone and more than
200,000 cases are pending in the Supreme Court for admission,
interim relief or final hearing.
This is not the full story. Since thousands of cases are pending in
the lower courts, legal experts suggest that the average time

taken by Indian courts for deciding a civil I case is around 7 to 10

years (Shah, 1998), if not more. The right of the lessor to
repossess the leased asset, in case of default by the lessee was
not very clear until the Bombay High Court ruled (and the
Supreme Court upheld) that the lessor has a right to so repossess
(in the case of Twentieth Century Finance Corporation vs. SLM
Maneklal Industries Ltd.). Hence the required rate of return due to
feeble contract enforcement mechanisms becomes larger in
countries like India. Therefore, a good portion of non-performing
assets of commercial banks in India is related to deficiencies in
contract enforcement mechanisms. Credit risk is also linked to
market risk variables. In a highly volatile interest rate
environment, loan defaults could increase thereby affecting credit
quality.
The expansion of banking sector was phenomenal during the

1970s and 1980s. Mobilization of deposits was one of the major
objectives of commercial banks. To that extent, performance
appraisal and incentive system within the banking sector was
more based on deposit mobilization and achievement of deposit
targets rather than on lending practices and credit risk
assessment mechanisms.
Hence, it is important that the banks reorient their approach in

terms of Reformulating performance appraisal systems, which
focus more on lending practices and credit risk assessments in
the changed scenario. Credit rating to some extent facilitates the
understanding of credit risk. But the quality of financial
information provided by Corporates leaves much to be desired. In
the case of the unincorporated sector, namely a partnership and
proprietorship firm, the task of credit risk assessment is more
complicated because of lack of reliable and continuous financial
information.
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.

For example, when someone invests $10,000 into the stock

market, he or she faces a capital risk on the $10,000 invested.
Similarly, if a company does not insure the value of some of its
assets, it will face capital risk from such things as fire, flood and
theft.
One of the sound aspects of the banking practice is the

maintenance of adequate capital on a continuous basis. There are
attempts to bring in global norms in this field in order to bring in
commonality and standardization in international practices.
Capital adequacy also 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.
Market risk:
Market Risk is common to an entire class of assets or liabilities.

The value of investments may decline over a given time period
simply because of economic changes or other events that impact
large portions of the market. Asset allocation and diversification
can protect against market risk because different portions of the
market tend to underperform at different times. It is also called
systematic risk.
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.
In the Indian context, 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.
Interest rate risk:
Interest risk is the change in prices of bonds that could occur as a

result of change: n interest rates. It also considers change in
impact on interest income due to changes in the rate of interest.
In other words, price as well as reinvestment risks require focus.
In so far as the terms for which interest rates were fixed on

deposits differed from those for which they fixed on assets, banks
incurred interest rate risk i.e., they stood to make gains or losses
with every change in the level of interest rates. 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.
In most OECD countries (Harrington, 1987), the situation was no

different from that which prevailed in domestic banking. The term
to maturity of a bond provides clues to the fluctuations in the
price of the bond since it is fairly well-known that longer maturity
bonds have greater fluctuations for a given change in the interest
rates compared to shorter maturity bonds. In other words
commercial banks, which are holding large proportions of longer
maturity bonds, will face more price reduction when the interest
rates go up. Between 1970s and the early part of 1990s, there
has been a substantial change in the maturity structure of bonds
held by commercial banks.
During 1961, 34% of the central government securities had a

maturity of less than 5 years and 27% more than 10 years. But in
1991, only 9% of the securities had a maturity of less than 5
years, while 86% were more than 10 years (Vaidyanathan, 1995).
During 1992, when the reform process started and efforts taken
to move away from the administered interest rate mechanism to
market determined rates, financial institutions were affected
because longer maturity instruments have greater fluctuations
for a given change in the interest rate structure. This becomes all
the grimmer when interest rates move up because the prices of
the holding came down significantly and in a marked-to-market
situation, severely affect bottom lines of banks.
Another associated issue is related to the coupon rate of the

bonds. Throughout the 1970s and 1980s, the government was
borrowing from banks using the statutory obligation route at
artificially low interest rates ranging between 4.5% to 8% (The
World Bank, 1995). The smaller the coupon rate of bonds, larger
is the fluctuation associated with a change in interest rate
structure. Because of artificially fixed low coupon rates,

commercial banks faced adverse situations when the interest rate

structure was liberalized to align with market rates.
Therefore, the banking industry in India has substantially more

issues associated with interest rate risk, which is due to
circumstances outside its control. This poses extra challenges to
the banking sector and to that extent; they have to adopt
innovative and sophisticated techniques to meet some of these
challenges. There are certain measures available to measure
interest rate risk. These include:
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:
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:
Dollar duration represents the actual dollar change in the market

value of a holding of the bond in response to a percentage
change in rates.
Convexity:

Because of a change in market rates and because of passage of

time, duration may not remain constant. With each successive
basis point movement downward, bond prices increase at an
increasing rate. Similarly if rates increase, the rate of decline of
bond prices declines. This property is called convexity.
In the Indian context, banks in the past were primarily concerned

about adhering to statutory liquidity ratio norms and to that
extent they were acquiring government securities and holding it
till maturity. But in the changed situation, namely moving away
from administered interest rate structure to market determined
rates, it becomes important for banks to equip themselves with
some of these techniques, in order to immunize banks against
interest rate risk.
Liquidity risk:
Liquidity risk affects many Indian institutions. It is the potential

inability to generate adequate cash to cope with a decline in
deposits or increase in assets. To a large extent, it is an outcome
of the mismatch in the maturity patterns of assets and liabilities.
First, the proportion of central government securities with longer
maturities in the Indian bond market, significantly increasing
during the 1970s and 1980s, affected the banking system
because longer maturity securities have greater volatility for a
given change in interest rate structure. This problem gets
accentuated in the context of change in the main liability
structure of the banks, namely the maturity period for term
deposits.
For instance in 1986, nearly 50% of term deposits had a maturity

period of more than 5 years and only 20%, less than 2 years for
all commercial banks. But in 1992, only 17% of term deposits
were more than 5 years whereas 38% were less than 2 years
(Vaidyanathan, 1995).
In such a situation, we find banks facing significant problems in

terms of mismatch between average life of bonds and maturity
pattern of term deposits. The Ministry of Finance as well as the
RBI has taken steps to reduce the average maturity period of
bonds held by commercial banks in the last few years. In other
words, newer instruments are being floated with shorter

maturities accompanied by roll over of earlier instruments with

shorter maturities. In order to meet short-term liability payments,
institutions have to maintain certain levels of cash at all points of
time. Thus managing cash flows becomes crucial. Institutions
could access low cost funding or could have assets that have
sufficient short-term cash flows. Hence, banking institutions need
to strike a reasonable trade off between being excessively liquid
and relatively illiquid.
The recent failure of many non-banking financial companies can

be ascribed to mismatch between asset-liability maturities, since
many of them have invested in real estate type of assets with
short-term borrowings. Particularly in a declining real estate
market, it becomes difficult for non-banking financial companies
to exit and meet obligations of lenders. In such a context,
liquidity becomes a much more significant variable even at the
cost of forgoing some profitability.
Types of Liquidity Risk:
 Liquidity Exposure can stem from both internally and externally.

 External liquidity risks can be geographic, systemic or instrument
specific.
 Internal liquidity risk relates largely to perceptions of an
institution in its various markets: local, regional, national or
international
 Funding Risk - Need to replace net outflows due to unanticipated
withdrawals/ non-renewal
 Time Risk - Need to compensate for non-receipt of expected
inflows of funds
 Call Risk - Crystallization of contingent liability
Yield Curve Risk:
Currently yield curve risk is limited in Indian Banks as mostly the

assets and liabilities in Indian banking system are either at fixed
rate or at floating rate linked to internal benchmarks.
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

relevance of benchmark PLR is itself questionable when banks are

lending at sub-PLR rates.
Currency Risk:
Floating exchange rate arrangement has brought in its wake

pronounced volatility adding a new dimension to the risk profile
of banks' balance sheets. The increased capital flows across free
economies following deregulation have contributed to increase in
the volume of transactions. Large cross border flows together
with the volatility has rendered the banks' balance sheets
vulnerable to exchange rate movements.
Dealing in different currencies brings opportunities as also risks. If

the liabilities in one currency exceed the level of assets in the
same currency, then the currency mismatch can add value or
erode value depending upon the currency movements. The
simplest way to avoid currency risk is to ensure that mismatches,
if any, are reduced to zero or near zero. Banks undertake
operations in foreign exchange like accepting deposits, making
loans and advances and quoting prices for foreign exchange
transactions. Irrespective of the strategies adopted, it may not be
possible to eliminate currency mismatches altogether. Besides,
some of the institutions may take proprietary trading positions as
a conscious business strategy.
Managing Currency Risk is one more dimension of Asset- Liability

Management. Mismatched currency position besides exposing the
balance sheet to movements in exchange rate also exposes it to
country risk and settlement risk. Ever since the RBI (Exchange
Control Department) introduced the concept of end of the day
near square position in 1978, banks have been setting up
overnight limits and selectively undertaking active day time
trading. Following the introduction of "Guidelines for Internal
Control over Foreign Exchange Business" in 1981, maturity
mismatches (gaps) are also subject to control. Following the
recommendations of Expert Group on Foreign Exchange Markets
in India (Sodhani Committee) the calculation of exchange position
has been redefined and banks have been given the discretion to
set up overnight limits linked to maintenance of additional Tier I
capital to the extent of 5 per cent of open position limit.

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:
Basis risk arises due to changes in market rates on different

financial instruments by varying degree. The risk that the interest
rate of different assets, liabilities and off-balance sheet items
may change in different magnitudes is termed as basis risk.
The degree of basis risk is fairly high in respect of banks that

create composite assets out of composite liabilities. For example,
a bank may be funding floating rate loans linked to its Benchmark
Prime Lending Rate (BPLR) through composite liabilities of various
maturities. The rates on these liabilities may change by different
degrees whereas the bank may not be able to change its BPLR by
same degree. This may result NII of the bank to shrink in a rising
interest rate scenario.
Embedded Option Risk:
Embedded option means possibility of alteration of cash flows to

the disadvantage of a bank. Traditionally banks have offered
products with embedded options. The depositors enjoy freedom
to close their deposits at any time by paying penalty. Similarly,
there are embedded options with loan products such as cash
credit, demand loans and term loans.
Banks are experiencing embedded option even in stable interest

rate environments due to stiff competition. Pre-payments in home
loans are regular phenomenon. However, in volatile interest rate
scenario, the degree of usage of embedded option goes up.
Banks statistically estimate the extent of embedded options to be
exercised by customers and incorporate them liquidity and
interest rate risk models. The pricing of such risks into deposit
and loan products has also to happen. Though Reserve Bank of

India has permitted banks to deny premature closures in case of

large deposits, they are currently not doing so due to fear of
losing business.
Price Risk:
Banks are required to mark to market their investment portfolio

in held for trading and available for sale category. In the financial
markets, prices of instruments and yields are inversely related.
During last three years prior to March 2004, due to slow credit
pick up, a large number of banks had invested in government
securities more than regulatory requirements.
As per Reserve Bank of India’s guidelines banks may classify their

investments into three categories viz. a) Held for Trading (HFT) b)
Available for Sale (AFS) and c) Held till Maturity (HTM). While
securities in HFT and AFS categories are required to be marked to
marked, the securities in HTM are not. As interest rates declined,
banks made huge treasury gains in their investment portfolio.
However, due to rise in yields many banks reported treasury
losses in December quarter 2004. The losses would have been
higher, had RBI not permitted banks to shift a portion of their
securities to ‘Held to Maturity’ class. However, notwithstanding
this accounting treatment, the rising interest rates will result in
economic loss of bonds held in held till maturity category.
Operational risk:
Operational risk is the risk of loss resulting from inadequate or

failed internal processes, people and system or from external
events. Operational risk is associated with human error, system
failures and inadequate procedures and controls. It is the risk of
loss arising from the potential that inadequate information
system; technology failures, breaches in internal controls, fraud,
unforeseen catastrophes, or other operational problems may
result in unexpected losses or reputation problems. Operational
risk exists in all products and business activities.

Operational risk event types that have the potential to result in

substantial losses includes Internal fraud, External fraud,
employment practices and workplace safety, clients, products
and business practices, business disruption and system failures,
damage to physical assets, and finally execution, delivery and
process management.
The objective of operational risk management is the same as for

credit, market and liquidity risks that is to find out the extent of
the financial institution’s operational risk exposure; to understand
what drives it, to allocate capital against it and identify trends
internally and externally that would help predicting it. The
management of specific operational risks is not a new practice; it
has always been important for banks to try to prevent fraud,
maintain the integrity of internal controls, and reduce errors in
transactions processing, and so on. However, what is relatively
new is the view of operational risk management as a
comprehensive practice comparable to the management of credit
and market risks in principles. Failure to understand and manage
operational risk, which is present in virtually all banking
transactions and activities, may greatly increase the likelihood
that some risks will go unrecognized and uncontrolled.
Operational Risk Management Principles:
There are 6 fundamental principles that all institutions, regardless

of their size or complexity, should address in their approach to
operational risk management.
a) Ultimate accountability for operational risk management rests

with the board, and the level of risk that the organization accepts,
together with the basis for managing those risks, is driven from
the top down by those charged with overall responsibility for
running the business.
b) The board and executive management should ensure that

there is an effective, integrated operational risk management
framework. This should incorporate a clearly defined
organizational structure, with defined roles and responsibilities
for all aspects of operational risk management/monitoring and
appropriate tools that support the identification, assessment,
control and reporting of key risks.

c) Board and executive management should recognize,

understand and have defined all categories of operational risk
applicable to the institution. Furthermore, they should ensure that
their operational risk management framework adequately covers
all of these categories of operational risk, including those that do
not readily lend themselves to measurement.
d) Operational risk policies and procedures that clearly define the

way in which all aspects of operational risk are managed should
be documented Managing Operational risk and communicated.
These operational risk management policies and procedures
should be aligned to the overall business strategy and should
support the continuous improvement of risk management.
e) All business and support functions should be an integral part of

the overall operational risk management framework in order to
enable the institution to manage effectively the key operational
risks facing the institution.
f) Line management should establish processes for the

identification, assessment, mitigation, monitoring and reporting
of operational risks that are appropriate to the needs of the
institution, easy to implement, operate consistently over time and
support an organizational view of operational risks and material
failures.
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.
If an investor is to realize the required yield on an investment in a

coupon bond, then he/she must be able to invest all of the
coupon payments at that same yield as well. This yield is called
yield to maturity, which refers to the percentage rate of return
paid on a bond if the investor buys and holds it to its maturity
date. If the coupon payments arrive when yields are lower, then
they can only be invested at lower rates. This is reinvestment

risk. It is the risk that proceeds available for reinvestment must

be reinvested at a lower interest rate than the instrument that
generated the proceeds.
Three factors affect this risk:
Maturity:
The yield to maturity measure for long-term coupon bonds tells

little about the potential yield that an investor may realize if the
bond is held to maturity. The risk that the coupon payments will
be reinvested at less than the original yield to maturity is the
reinvestment risk. The longer the maturity, the bigger the
reinvestment risk.
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.
Call, prepayment options and amortizing securities:
The reinvestment risk is even greater for these kinds of

securities. A callable bond has higher reinvestment risk than a
standard bond, because it is likely that the cash flows of the
callable bond may be received faster due to the call feature. In a
declining interest rate environment borrowers will accelerate
their prepayments and force the investor to reinvest more
proceeds at lower interest rates.
Risk Measurement Techniques:
There are various techniques for measuring exposure of banks to

interest rate risks:
Gap analysis model:

Measures the direction and extent of asset-liability mismatch

through either funding or maturity gap. It is computed for assets
and liabilities of differing maturities and is calculated for a set
time horizon. This model looks at the repricing gap that exists
between the interest revenue earned 9n the bank's assets and
the interest paid on its liabilities over a particular period of time
(Saunders, 1997). It highlights the net interest income exposure
of the bank, to changes in interest rates in different maturity
buckets. Repricing gaps are calculated for assets and liabilities of
differing maturities.
A positive gap indicates that assets get repriced before liabilities,

whereas, a negative gap indicates that liabilities get repriced
before assets. The bank looks at the rate sensitivity (the time the
bank manager will have to wait in order to change the posted
rates on any asset or liability) of each asset and liability on the
balance sheet. The general formula that is used is as follows:
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.
Limitations of GAP Analysis:
1. The gap is computed as the rupee difference between the

values of rate sensitive assets and liabilities in the gapping period
regardless of when the repricing occurs. Thus if all assets re-price
at the beginning of the maturity period and the liabilities at the
end of the period the institution will not be insulated from interest
rate risk even though the gap is maintained at zero.

2. The gap management might be hampered by the objectives of

the customers. In rising interest rate scenarios gap management
recommends shifting out of fixed rate assets to floating rate
assets. The customers may however demand fixed rate assets.
Additionally such adjustments in assets/liabilities may have to be
accomplished at the cost of trading off lower interest rate risk for
greater credit and default risk.
3. Alternatively, such assets may be swapped at floating rate

through OIS. However, there has to be a definite view on
magnitude as well as quantum of interest rate increase, as there
will be opportunity loss through negative carry at the beginning.
4. Gap management does not take into account that re-pricing

spreads of assets and liabilities which may not be identical i.e. it
is possible that the rise in interest rates on liabilities is
proportionately higher than rise in interest rate on assets leading
to a decline in spreads despite an increase in the general level of
rates.
5. Gap management concentrates solely on flow of funds and

variability of revenues and does not focus on the effect of interest
rate on the market value of assets and liabilities.
Duration model:
Duration is an important measure of the interest rate sensitivity

of assets and liabilities as it takes into account the time of arrival
of cash flows and the maturity of assets and liabilities. It is the
weighted average time to maturity of all the preset values of cash
flows. Duration basically refers to the average life of the asset or
the liability.
DP p = D ( dR /1+R)
The above equation describes the percentage fall in price of the

bond for a given increase in the required interest rates or yields.
The larger the value of the duration, the more sensitive is the
price of that asset or liability to changes in interest rates. As per
the above equation, the bank will be immunized from interest
rate risk if the duration gap between assets and the liabilities is

zero. The duration model has one important benefit. It uses the
market value of assets and liabilities.
Value at Risk:
Value at risk refers to the maximum expected loss that a bank

can suffer over a target horizon, given a certain confidence
interval. It enables the calculation of market risk of a portfolio for
which no historical data exists. It enables one to calculate the net
worth of the organization at any particular point of time so that it
is possible to focus on long-term risk implications of decisions
that have already been taken or that are going to be taken. It is
used extensively for measuring the market risk of a portfolio of
assets and/or liabilities.
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.
Generally there are three ways of computing VAR:
 Parametric method or Variance covariance approach

 Historical Simulation
 Monte Carlo method
Banks are encouraged to calculate their risk profile using VAR

models. At the minimum banks are expected to adopt relatively
simple risk measurement methodologies such as maturity
mismatches, sensitivity analysis etc.
Simulation:

Simulation models help to introduce a dynamic element in the

analysis of interest rate risk. Gap analysis and duration analysis
as stand-alone too1for 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, for example:
What if:
 The absolute level of interest rates shift

 There are nonparallel yield curve changes
 Marketing plans are under-or-over achieved
 Margins achieved in the past are not sustained / improved
 Bad debt and prepayment levels change in different interest
rate scenarios
 There are changes in the funding mix e.g.: an increasing
reliance on short term funds for balance sheet growth.
This dynamic capability adds value to the traditional methods and

improves the information available to management in terms of:
 Accurate evaluation of current exposures of asset and

liability portfolios to interest rate risk
 Changes in multiple target variables such as net interest
income, capital adequacy, and liquidity
 Future gaps
It is possible that the simulation model due to the nature of

massive paper outputs may prevent us from seeing wood for the
tree. In such a situation, it is extremely important to combine
technical expertise with an understanding of issues in the
organization. There are certain requirements for a 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 managers may 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 caution particularly in the Indian

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.
Pre - Conditions for the Success of ALM in Banks:
1. Awareness for ALM in the Bank staff at all levels is a must.

Thus the banks must have a supportive management & dedicated
teams in order to make sure that there is sufficient awareness
about the importance and significance of asset liability
management among bank staff at all levels. This will enable the
bank to take corrective strategies in case of mismatch.
2. Method of reporting data from Branches / other Departments.

(I.e. Strong MIS). If a bank has a strong MIS then it would not only
be able to meet all its set targets efficiently but also enhance the
banks overall profitability.
3. A bank must have full computerization and networking

because only then it would be able to perform its tasks well and
in an efficient manner. It will also give it a competitive edge and
help to achieve a reliable position in the eyes of its customers.
4. There must be sufficient insight into the banking operations,

economic forecasting, computerization, investment and credit.
This will enable the bank to take required steps in case of any
crisis or financial instability.

5. It is necessary to link up ALM to future Risk Management

Strategies. This will help the bank to take the right decisions at
the right time and frame risk management strategies accordingly.
This will enable the bank to avoid difficulties and hindrances in
performing its operational functions efficiently.
Asset - Liability Management Strategies for

Correcting Mismatch:
The strategies that can be employed for correcting the mismatch

in terms of D (A) > D (L) can be either liability or asset driven.
Asset driven strategies for correcting the mismatch focus on
shortening the duration of the asset portfolio. The commonly
employed asset based financing strategy is securitization.
Typically the long-term asset portfolios like the lease and hire
purchase portfolios are securitized; and the resulting proceeds
are either redeployed in short term assets or utilized for repaying
short-term liabilities.
Liability driven strategies basically focus on lengthening the

maturity profiles of liabilities. Such strategies can include for
instance issue of external equity in the form of additional equity
shares or compulsorily convertible preference shares (which can
also help in augmenting the Tier I capital of finance companies),
issue of redeemable preference shares, subordinated debt
instruments, debentures and accessing long term debt like bank
borrowings and term loans. Strategies to be employed for
correcting a mismatch in the form of D (A) < D (L) (which will be
necessary if interest rates are expected to decline) will be the
reverse of the strategies discussed above.
Asset driven strategies focus on lengthening the maturity profile

of assets by the deployment of available lendable resources in
long-term assets such as lease and hire purchase. Liability driven
strategies focus on shortening the maturity profile of liabilities,
which can include, liquidating bank borrowings which are
primarily in the form of cash credit (and hence amenable for
immediate liquidation), using the prepayment options (if any
embedded in the term loans); and the call options, if any
embedded in bonds issued by the company; and raising short-

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

repay long-term borrowings.
Positive Mismatch: M.A.>M.L. & Negative Mismatch: M.L.>M.A.
In case of positive mismatch, excess liquidity can be deployed in

money market instruments, creating new assets & investment
swaps etc.
For negative mismatch, it can be financed from market

borrowings (Call/Term), Bills rediscounting, Repos & deployment
of foreign currency converted into rupee.
Strategy: To meet the mismatch in any maturity bucket, the bank

has to look into taking deposit and invest it suitably so as to
mature in time bucket with negative mismatch. The bank can
raise fresh deposits of Rs 300 crore over 5 year’s maturities and
invest it in securities of 1-29 days of Rs 200 crores and rest
matching with other out flows.
Maturity Pattern of Assets & Liabilities of a Bank:

Rupees
Liability/Assets In Percentage
(In Cr)
I. Deposits 15200 100

a. Up to 1 year 8000 52.63
b. Over 1 yr to 3 yrs 6700 44.08
c. Over 3 yrs to 5 yrs 230 1.51
d. Over 5 years 270 1.78
II. Borrowings 450 100
a. Up to 1 year 180 40.00
b. Over 1 yr to 3 yrs 00 0.00
d. Over 5 years 120 26.67
III. Loans & Advances 8800 100
a. Up to 1 year 3400 38.64
b. Over 1 yr to 3 yrs 3000 34.09
d. Over 5 years 2000 22.72
Iv. Investment 5800 100
a. Up to 1 year 1300 22.41
b. Over 1 yr to 3 yrs 300 5.17
d. Over 5 years 3300 56.90
Information Technology and Asset - Liability

Management in the Indian context:
Many of the new private sector banks and some of the non-
banking financial companies have gone in for complete

computerization of their branch network and have also integrated

their treasury, Forex, and lending segments. The information
technology initiatives of these institutions provide significant
advantage to them in asset-liability management since it
facilitates faster flow of information, which is accurate and
reliable. It also helps in terms of quicker decision-making from the
central office since branches are networked and accounts are
considered as belonging to the bank rather than a branch.
The electronic fund transfer system as well as Demat holding of

securities also significantly alters mechanisms of implementing
asset-liability management because trading, transaction, and
holding costs get reduced. Simulation models are relatively easier
to consider in the context of networking and also computing
powers. The open architecture, which is evolving in the financial
system, facilitates cross-bank initiatives in asset-liability
management to reduce aggregate unit cost. This would prove as
a reliable risk reduction mechanism. In other words, the
boundaries of asset-liability management architecture itself is
changing because of substantial changes brought about by
information technology, and to that extent the operations
managers are provided with multiple possibilities which were not
earlier available in the context of large numbers of branch
networks and associated problems of information collection,
storage, and retrieval.
In the Indian context, asset-liability management refers to the

management of deposits, credit, investments, borrowing, Forex
reserves and capital, keeping in mind the capital adequacy norms
laid down by the regulatory authorities. Information technology
can facilitate decisions on the following issues:
 Estimating the main sources of funds like core deposits,

certificates of deposits, and call borrowings.
 Reducing the gap between rate sensitive assets and rate
sensitive liabilities, given a certain level of risk.
 Reducing the maturity mismatch so as to avoid liquidity
problems.
 Managing funds with respect to crucial factors like size and
duration.

Emerging Issues in the Indian context:
With the onset of liberalization, Indian banks are now more

exposed to uncertainty and to global competition. This makes it
imperative to have proper asset-liability management systems in
place.
The following points bring out the reasons as to why asset-liability

management is necessary in the Indian context:
1. In the context of a bank, asset-liability management refers to

the process of managing the net interest margin (NIM) within a
given level of risk. NIM = Net Interest Income/Average Earning
Assets = NII/AEA
Since NII equals interest income minus interest expenses, thus

NIM can be viewed as the spread on earning assets and uses the
term spread management. As the basic objective of banks is to
maximize income while reducing their exposure to risk, efficient
management of net interest margin becomes essential.

2. Several banks have inadequate and inefficient management

systems that have to be altered so as to ensure that the banks
are sufficiently liquid.
3. Indian banks are now more exposed to the vagaries of the

international markets, than ever before because of the removal of
restrictions, especially with respect to Forex transactions. Asset-
liability management becomes essential as it enables the bank to
maintain its exposure to foreign currency fluctuations given the
level of risk it can handle.
4. An increasing proportion of investments by banks are being

recorded on a marked-to-market basis and as such large portion
of the investment portfolio is exposed to market risks. Countering
the adverse impact of these changes is possible only through
efficient asset-liability management techniques.
5. As the focus on net interest margin has increased over the

years, there is an increasing possibility that the risk arising out of
exposure to interest rate volatility will be built into the capital
adequacy norms specified by the regulatory authorities. This, in
turn will require efficient asset-liability management practices.

Conclusion:
It is important to note that the conglomerate approach to

financial institutions, which is increasingly becoming popular in
the developed markets, could also get replicated in Indian
situations. This implies that the distinction between commercial
banks and term lending institutions could become blurred. It is
also possible that the same institution involves itself in short-term
and long-term lending-borrowing activities, as well as other
activities like mutual funds, insurance and pension funds.
In such a situation, the strategy for asset-liability management

becomes more challenging because one has to adopt a modular
approach in terms of meeting asset liability management
requirements of different divisions and product lines. But it also
provides opportunities for diversification across activities that
could facilitate risk management on an enhanced footing. In other
words, in the Indian context, the challenge could arise from say
the merger of SBI, IDBI, and LIC.
Such a scenario need not be considered extremely hypothetical

because combined and stronger balance sheets provide much
greater access to global funds. It also enhances the capability of
institutions to significantly alter their risk profiles at short notice
because of the flexibility afforded by the characteristics of
products of different divisions. This also requires significant
managerial competence in order to have a conglomerate view of
such organizations and prepare it for the challenges of the
coming decade.
As long as the artificial barriers between different financial

institutions exist, asset liability management is narrowly focused
and many a time not in a position to achieve the desired
objectives. This is because of the fact that the institutional
arrangements are mainly due to historical reasons of convenience
and a perceived static picture of the operating world. The
integration of different financial markets, instruments and
institutions provide greater opportunities for emerging markets
like India to aim for higher return in the context of minimizing
risk.

Hence, it maybe appropriate to think in terms of reorienting our

institutional structures (removing the distinctions between
commercial banks, non-banking financial companies, and term
lending institutions to start with) and having a conglomerate
regulatory framework for monitoring capital adequacy, liquidity,
solvency, marketability, etc. This will go a long way in ironing out
the mismatches between the assets and the liabilities, rather
than narrowly focused asset-liability management techniques for
individual banks.
Bibliography:
Websites:
 www.wikipedia.com
 www.google.com
 www.businessworld.com
 www.economictimes.com
Reference books:
 Bank Asset & Liability Management: Strategy, Trading,

Analysis (Wiley Finance) by Moorad Choudhry

 Financial Risk Management In Banking: The Theory and

Application of Asset and Liability Management by Dennis G.
Uyemura and Donald R. van Deventer
 Asset and Liability Management Tools: A Handbook for Best
Practice by Bernd Scherery

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REPORT On Asset

Reshma Fernandes (312)

PGDBM Finance (2007-09)

N.L.Dalmia Institute of Management Studies and Research

This is to certify that Miss. Reshma Fernandes student of N.L.

Prof. V.S Date Prof. P.L.

(Project Guide) (Director,

My special thanks to all the professors for imparting useful

N.L.Dalmia Institute of Management Studies and Research 2

I also extend my gratitude to Prof. Vinayak Date, our Course

(PGDBM Finance, 2007-09)

 Asset - Liability Management concept and its Emergence

N.L.Dalmia Institute of Management Studies and Research 3

 Information Technology and Asset - Liability Management in

Asset - Liability Management concept and its

In banking, asset liability management is the practice of

Banks manage the risks of Asset liability mismatch by matching

Modern risk management now takes place from an integrated

Asset-liability management (ALM) is a term whose meaning has

N.L.Dalmia Institute of Management Studies and Research 4

also apply ALM techniques. This article describes ALM as a

Traditionally, banks and insurance companies used accrual

Consider a bank that borrows USD 100MM at 3.00% for a year

Suppose, at the end of a year, an applicable 4-year interest rate

100MM (1.032) = 103.2MM.

The book value of the financing (the bank's liability) is:

100MM (1.030) = 103.0MM.

Based upon accrual accounting, the bank earned USD 200,000 in

Market value accounting recognizes the bank's predicament. The

N.L.Dalmia Institute of Management Studies and Research 5

100MM (1.030) = 103.0MM.

From a market-value accounting standpoint, the bank has lost

So which result offers a better portrayal of the bank's situation,

The problem in this example was caused by a mismatch between

Things started to change in the 1970s, which ushered in a period

One example is the US mutual life insurance company the

N.L.Dalmia Institute of Management Studies and Research 6

principal of USD 100MM or more. Equitable invested the assets

Increasingly, managers of financial firms focused on asset-liability

Exhibit 1 illustrates the evolution over time of a hypothetical

Example: Asset-Liability Risk

Asset-liability risk is leveraged by the fact that the values of

N.L.Dalmia Institute of Management Studies and Research 7

capital. In this example, modest fluctuations in values of assets

Accrual accounting could disguise the problem by deferring

Techniques for assessing asset-liability risk came to include gap

With scenario analysis, several interest rate scenarios would be

Next, assumptions would be made about the performance of

N.L.Dalmia Institute of Management Studies and Research 8

In a sense, ALM was a substitute for market-value accounting in a

Firms recognized a potential for liquidity risks to be overlooked in

Techniques of ALM have also evolved. The growth of OTC

The scope of ALM activities has widened. Today, ALM

N.L.Dalmia Institute of Management Studies and Research 9

Corporations have adopted techniques of ALM to address

There are two types of ALM analysis:

Analytical: This includes liquidity and sensitivity gaps, sensitivity

Numerical: This includes stress scenario and Value at Risk (VaR)

Asset - Liability Management in Banks:

Ever since the initiation of the process of deregulation of the

N.L.Dalmia Institute of Management Studies and Research 10

One reason for this neglect appears to be a wrong notion among