ASSET LIABILITY MANAGEMENT

MODULE A
C.S.BALAKRISHNAN
FACULTY MEMBER,SPBT COLLEGE
 COMPONENTS OF ASSETS & LIABILITIES IN
BANK’S BALANCE SHEET AND THEIR
MANAGEMENT
• Bank’s Liabilities
-The sources of funds for the lending and
investment activities constitute liabilities side of
balance sheet.
Capital
Reserves and Surplus
Deposits
Borrowings
Other Liabilities and Provisions
Contingent Liabilities.
 Bank’s Assets are the funds mobilised by bank
through various sources.
-Cash and Bank balances with Reserve Bank
Of India.
-Balances with banks and money at call and
short notice.
-Investments
-Advances
-Fixed Assets
-Other Assets.
 Business of banking involves the
identifying,measuring,accepting and
managing the risk,the heart of bank financial
management is risk management.One of the
most important risk-managemnet functions in
bank is Asset Liability Management.
 Traditionally,administered interest rates were
used to price the assets and liabilities of
banks.However,in the deregulated
environment,competition has narrowed the
spreads of banks.
 Asset Liability Management is concerned with
strategic balance sheet management involving
risks caused by changes in interest
rates,exchange rate,credit risk and the liquidity
position of bank.With profit becoming a key-
factor,it has now become imperative for banks
to move towards integrated balance sheet
management where components of balance
sheet and its different maturity mix will be
looked at profit angle of the bank.
 ALM is about management of Net Interest
Margin(NIM) to ensure that its level and riskiness
are compatible with risk/return objectives of the
bank.It is more than just managing individual assets
and liabilities.It is an integrated approach to bank
financial management requiring simultaneous
decision about types and amount of financial assets
and liabilities it holds or its mix and volume.In
addition ALM requires an understanding of the
market area in which the bank operates.
 If 50% of the liabilities are maturing within 1
year but only 10% of the assets are maturing
within the same period.Though the financial
institution has enough assets,it may become
temporarily insolvent due to a severe liquidity
crisis.
 Thus,ALM is required to match assets &
liabilities and minimise liquidity as well as
market risk.
 Reasons for growing significance of ALM
-Volatility
-Product Innovation
-Regulatory Framework
-Management Recognition
 An effective Asset Liability Management
technique aims to manage the volume
mix,maturity,rate sensitivity,quality and
liquidity of assets and liabilities as a whole
so as to attain a predetermined acceptable
risk/reward ratio.
Purpose and objectives of asset liability
management
 Review the interest rate structure and compare
the same to the interest/product pricing of
both assets and liabilities.
 Examine the loan and investment portfolios in
the light of the foreign exchange risk and
liquidity risk that might arise.
 Examine the credit risk and contingency risk
that may originate either due to rate
fluctuations or otherwise and assess the quality
of assets.
 Review,the actual performance against the
projections made and analyse the reasons for
any effect on spreads.
 Aim is to stabilise the short-term profits,long-
term earnings and long-term substance of the
bank.The parameters that are selected for the
purpose of stabilising 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 InterestIncome/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.
 ALM is required to match assets and liabilities
to ---------liquidity risk as well as market risk.
 The ratio of shareholders funds to the total
assets is called-------.
 Net Interest Margin is defined as net interest
income divided by ---------.
 Liquidity is ensured by grouping the
assets/liabilities based on their ------.
 The institution is in a position to benefit from
rising interest rates when assets are ------ than
liabilities
State True or False
 Assets represent source of funds whereas
liabilities denote the use of funds in a balance
sheet.
 Deregulated environment has narrowed
spreads of the banks.
 Asset liability management is only management
of maturity mismatch and has no bearing on
profit augmentation.
 Net Interest Margin is known as ‘Spread’
 LIQUIDITY MANAGEMENT
 Banks need liquidity to meet deposit
withdrawal and to fund loan demands.
 The variability of loan demands and variability
of deposits determine bank’s liquidity needs.It
represents the ability to accommodate
decreases in liability and to fund increases in
assets.
 It demonstrates the market place that the
bank is safe and therefore capable of repaying
its borrowings.
 It enables bank to meet its prior loan
commitments,whether formal or informal.
 It enables bank to avoid the unprofitable sale
of assets.
 It lowers the size of the default risk premium
the bank must pay for funds.
Types of liquidity risk:
-Funding Risk
-Time Risk
-Call Risk.
 Funding Risk:
Need to replace net outflows due to
unanticipated withdrawal/non-renewal of
deposits arises due to :
-Fraud causing substantial loss
-Systemic Risk
-Loss of confidence
-Liabilities in foreign currencies
 Time Risk:
Need to compensate for non-receipt of
expected inflow of funds,arises due to,
-Severe deterioration in the asset quality
-Standard assets turning into non-performing
assets
-Temporary problems in recovery
-Time involved in managing liquidity.
 Call Risk:Crystallisation of contingent liabilities
and inability to undertake profitable business
oppurtunities when desirable,arises due to,
-Conversion of non-fund based limit into fund
based.
-Swaps and options.
Measuring and Managing Liquidity Risk
 Developing a structure for managing liquidity
risk.
 Setting tolerance level and limit for liquidity
risk.
 Measuring and managing liquidity risk.
 Setting tolerance level for a bank:
To manage the mismatch levels so as to avert
wide liquidity gaps-The residual maturity
profile of assets and liabilities will be such that
mismatch level for time bucket of 1-14 days
and 15-28 days remain around 20% of cash
outflows in each time bucket.

To manage liquidity and remain solvent by

maintaining short-term cumulative gap up to
one year(short term liabilities-short term
assets at 15% of total outflow of funds.
 Measuring and Managing Liquidity Risk
Stock Approach
Flow Approach
Stock Approach is based on the level of assets and
liabilities as well as off balance sheet exposures on
a particular date.The following ratios are calculated
to assess the liquidity position of the bank:
Ratio of core deposits to total assets
Net loans to total deposits ratio
Ratio of time deposits to total deposits
Ratio of volatile liabilities to total assets
 Ratio of short term liabilities to liquid assets
 Ratio of liquid assets to total assets
 Ratio of short term liabilities to total assets
 Ratio of prime assets to total assets
 Ratio of market liabilities to total assets.
Flow Approach
-Measuring and managing net funding
requirements.
-Managing Market Access
-Contingency Planning
Measuring and Managing net funding
Requirements:
Flow method is the basic approach followed by
Indian Banks.It is called as gap method of
measuring and managing liquidity.It requires the
preparation of structural liquidity gap report.In
this method net funding requirement is
calculated on the basis of residual maturiries of
assets & liabilities.These residual maturities
represent net cash flows ie.difference between cash
outflow & cash inflow in future time buckets
 These calculations are based on the past
behaviour pattern of assets and liabilities as
well as off balance sheetexposures.Cumulative
gap is calculated at various time buckets.In
case gap is negative bank has to manage the
shortfall.
 The analysis of net funding requirements
involves the construction of a maturity ladder
and the calculation of a cumulative net excess
or deficit of funds at selected maturity dates.
 Objective of liquidity management is to
a)Ensure profitability
b)Ensure liquidity
c)Either of two
d)Both
 Banks need liquidity to
a) Meet deposit withdrawal
b) Fund loan demands
c) Both of them
d) None of them.
 Adequacy of a bank’s liquidity position
depends upon:
a)Sources of funds
b)Anticipated future funding needs
c)Present and Future earnings capacity
d)All the above
 The need to replace net outflows due to
unanticipated withdrawal of deposits is known
as ---------risk.
 The need to compensate for non-receipt of
expected inflows of funds is classified as
-----risk.
 Call risk arises due to crystallisation of ------.
 Maturity ladders enables the bank to estimate
the difference between-----and------in
predetermined periods.
 Liquidity management methodology of
evaluating whether a bank has sufficient liquid
funds based on the behaviour of cash flows
under different what if scenarios is known as
-------.
 The capability of bank to withstand a net
funding requirement in a bank specific or
general market liquidity crisis is denoted as----
INTEREST RATE RISK
MANAGEMENT
 Interest rate risk is the volatility in net interest
income(NII) or in variations in net interest
margin(NIM).
 Gap:The gap is the difference between the
amount of assets and liabilities on which the
interest rates are reset during a given period.
 Basis risk:The risk that the interest rate of
different assets and liabilities may change in
different magnitudes is called basis risk.
 Embedded option:Prepayment of loans and
bonds and/or premature withdrawal of
deposits before their stated maturity dates.
 Yield curve:It is a line on a graph plotting the
yield of all maturities of a particular instrument.
Changes in interest rates also affect the
underlying value of the bank’s--------
Rise in interest rates-----the market value of that
asset and fall in interest rate ----the market value
of assets or liabilities.
The gap is the difference between the amount
of assets and liabilities on which interest rates
are------during a given period
• Mismatch occurs when assets and liabilities
fall due for -----in different periods
• The economic value of a bank can be viewed
as the present value of the bank’s expected
-------.
Estimates derived from a standard duration
generally focus on just one form of interest
rate risk exposure ie.-----
The adverse impact on NII due to mismatches
can be minimised by fixing appropriate ----on
interest rate sensitivity gaps.
Management of Exchange Rate
Risk
• Foreign exchange risk-Risk arising out of
adverse exchange rate movementsduring a
period in which it has open position in an
individual foreign currency.
• Transaction exposure:Change in the foreign
exchange rate between the time the
transaction is executed and the time it is
settled.
• Forwards-Agreement to buy or sell forex for a
predetermined amount,at a predetermined
rate on a predetermined date.
 Open position:The extent to which
outstanding contracts to purchase a currency
exceed liabilities plus outstanding contractsto
sell the currency & vice versa.
 Overnight position-A limit on the maximum
open position left overnight,in all major
currencies.
 Day-light position-A limit on maximum open
position in all major currencies at any point of
time during day.Such limits are generally
larger than overnight positions.
• Options:It is a contract for future delivery of a
currency in exchange for another,where the
holder of the option has the right,without
obligation to buy or sell the currency at an
agreed price,the strike price or exercise price,on
a specified future date.
• Call option;The right to buy under an option
• Put option:The right to sell under an option.
• Futures are forward contracts with standardized
size,standardised maturity date governed by a
set of guidelines stipulated by exchange
concerned for settlements and payments.
An appreciation in domestic currency will----
value of assets and liabilities.
In a forward contract actual cash flow occurs on
the date of-----
Swaps can be of two types----and------
RBI GUIDELINES
Any questions
Thank you