Asset-Liability Management in Banks

Asset-Liability Management (ALM)

Bankers make decisions every day about buying and selling securities, about whether to make particular loans, and about how to fund their investment and lending activities. These decisions are partly based on the outlook of interest rates. Further, bankers take into account the composition of their assets and liabilities, as well as the degree of risk they are willing to take. The process of making such decisions is known as assetliability management (ALM). The Asset Liability Management Committee (ALCO) has the overall responsibility for managing the sources and uses of funds on the balance sheet and off-balance sheet activities with respect to interest rate risk and liquidity. ALM is generally viewed as short-term in nature, with the aim of achieving near-term financial goals.

Liquidity Risk Management

The object of any ALM policy is ensuring both profitability and liquidity. Usually a bank maintains profitability by borrowing short and lending long. However, in order to ensure that a potentially illiquid position is avoided, maturity matching has to be ensured. A bank generally aims to eliminate the liquidity risk while it only tries to manage the interest rate risk. This is because elimination of interest rate risk is not profitable.

Liquidity Risk Management

In liquidity risk management, the focus is on the liquidity position of the bank. The bank would estimate its cash requirements and the cash inflows and adjust these two to ensure a safe level for its liquidity position. All deposits based on their maturity fall under the categories: volatile funds, vulnerable funds and stable funds. Volatile funds include those deposits which are sure to be withdrawn during the period for which the liquidity estimate is to be made. These include short- term deposits. Float funds are also treated as volatile deposits.

Liquidity Risk Management

Deposits which are likely to be withdrawn during the planning tenure are categorized as vulnerable deposits. For e.g., a bank would know which part of savings deposits are stable and which portion is vulnerable. Finally, the residual deposits are stable deposits. Having obtained the consolidated / component-wise working funds, the bank will now have to estimate the average cash and bank balances that are to be maintained. This average balance can be maintained as a percentage to the total working funds. This average is based on forecasts, and hence a safety margin should also be ensured. Any balance beyond this range will necessitate corrective action either by deploying the surplus funds or by borrowing funds to meet the deficit. This acceptance level is, however, a dynamic figure which will change over time.

ALM Implementation
RBI has initiated an ALM framework in India based on Gap Analysis. Based on the RBI model, banks can segregate their assets and liabilities into various maturity buckets and also identify those assets and liabilities that are interest sensitive. While deciding about liquidity requirements, in certain cases the RBI has only provided benchmarks. Liquidity limits for the different time buckets can be set by the particular bank given its past experience of volatile and core portion of savings/ current account deposits.

Maturity Gap Method

Initially the RBI has considered the traditional Gap analysis as a suitable method. Later the banks should move over to more sophisticated methods including Duration Gap analysis and Simulation Models Each bank should set prudential limits on individual Gaps with the approval of the Board / Management Committee. The following time buckets are considered: 1 to 14 days 15 to 28 days 29 days to 3 months Over 3 months to 6 months Over 6 months to 1 year Over 1 year to 3 years Over 3 years to 5 years Over 5 years Non-sensitive

Liquidity Risk Management

RBI has suggested maturity profiling in terms of outflows and inflows while arriving at liquidity prognosis. A Statement of Structural Liquidity may be prepared by placing all cash inflows and outflows in the maturity ladder. A maturing liability will be a cash outflow while a maturing asset will be a cash inflow. Contingent liabilities also need to be taken into account.

Liquidity Risk Management

According to the latest guidelines, the banks may adopt a more granular approach to measurement of liquidity risk by splitting the first time bucket (1-14 days at present) in the Statement of Structural Liquidity into three time buckets viz. Next day , 2-7 days and 8-14 days. The net cumulative negative mismatches during the next day, 2-7 days, 8-14 days and 15-28 days buckets should not exceed 5 % ,10%, 15 % and 20 % of the cumulative cash outflows in the respective time buckets in order to recognise the cumulative impact on liquidity. The Statement of Structural Liquidity may be compiled on best available data coverage, in due consideration of nonavailability of a fully networked environment. Banks may, however, make concerted and requisite efforts to ensure coverage of 100 per cent data in a timely manner.

Liquidity Risk Management

Banks may undertake dynamic liquidity management and should prepare the Statement of Structural Liquidity on daily basis. The Statement of Structural Liquidity, may, however, be reported to RBI, once a month, as on the third Wednesday of every month. Within each time bucket there could be mismatches depending upon cash inflows and outflows. While the mismatches up to one year would be relevant, the main focus should be on the short term mismatches, viz. 1-14 days and 15-28 days. Further, in order to enable banks to monitor their shortterm liquidity on a dynamic basis over a time horizon from 1-90 days, banks may estimate their short-term profiles on the basis of business projections and other commitments for planning purposes.

Some Key Liquidity Ratios

Loan to deposit ratio = Performing loans outstanding/ Deposit balances outstanding Incremental loan to deposit ratio = Incremental loans to deposits during the period/ Incremental deposit inflows during the same period Medium term funding ratio = Liabilities with maturity over one year/ Assets with maturity over one year Cash flow coverage ratio = Projected cash inflow/ Projected cash outflow Liquid assets ratio = Liquid assets/ Short term liabilities Contingent liabilities ratio = Contingent liabilities/ Total loans

Managing Interest Rate Risk

Managing Interest Rate Risk

Before the liberalisation of the financial markets in 1991, most of the interest rates were not subject to regular changes, and hence ALM was not given much importance. However, in recent years, there has been a sea-change in approach. Today management of bank portfolios involves managing both assets and liabilities. On balance sheet adjustment involves changing the portfolio of assets and liabilities includes steps such as adjusting the maturity, repricing, and payment schedules. In addition, the bank could buy or sell securitised assets. Off-Balance Sheet adjustments include changing the interest position of a bank by using off-balance sheet derivatives, such as interest rate swaps and futures.

Concept of Net Interest Income

Liabilities Equity 30-day deposits@4% Total 90 mio 100 mio Total 100 mio Assets 10 mio 5 yr fixed rate loans @8% 100 mio

The net interest income (NII) = Interest Income Interest Expense = Rs. (8 3.6) mio = Rs. 4.4 mio Net Interest Margin (NIM) = NII/ Earning Assets = 4.4/100 = 4.4%. If market rates of interest increase, the cost of short-term borrowings will increase, and NII will decrease as loans are at long term fixed rates. On the other hand, if market rates of interest decrease, then NII will increase. The mix of all the assets and liabilities will decide the net effect on NII.

Maturity Gap Method

The maturity gap method of ALM technique aims to tackle the interest rate risk by highlighting the gap that exists between the Risk Sensitive Assets (RSAs) and Risk Sensitive Liabilities (RSLs), the maturity periods of the same and the gap period. The objective of this method is to stabilize/ improve the net interest income in the short run over discrete periods of time called the gap periods. The first step is to collect the gap periods, say anywhere between one month to one year. Having chosen the gap periods, all the RSAs and RSLs are grouped into `maturity buckets based on the maturity and the time until the first possible repricing due to change in interest rates.

Maturity Gap Method

Rate Sensitive Gap (RSG) = RSAs RSLs Also Gap Ratio or Interest Rate Sensitivity Ratio = RSAs/ RSLs The gap so analysed can be used by the treasury department to tackle the rising/ falling interest rate structures. For example, when RSG is positive, the consequence of a rate fluctuation is an increase in the net interest income when the interest rates rise and a decrease in the same when the rates fall. The opposite is true when RSG is negative: the consequence of a rate fluctuation is a decrease in the net interest income when the interest rates rise and an increase in the same when rates fall.

Maturity Gap Method

The process of maturity gap approach assesses the impact of a percentage change in interest rates on Net Interest Income (NII). The objective of an ALM policy will be to maintain the NIM (net interest margin) within certain limits by managing the risks. The following steps are therefore involved for a bank: Assess the percentage change in NIM that is acceptable to the bank Make a forecast for the quantum and direction of the interest rate change Based on the above determine the gap level (positive/ negative)

GAP and Net Interest Margin Example

(Rs. In Crores) Total Assets RSAs RSLs GAP (RSAs RSLs) GAP ratio (RSAs/RSLs) NII (assumed) Decease in interest rate Change in NII (GAP x r) Bank A 1000 40 20 20 2 200 2% -0.4 Bank B 1000 400 200 200 2 200 2% -4

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

Limitations of Maturity Gap Approach

Depends upon accuracy of interest rate forecasts may not be correct While gap measurement is a comparatively easy task, gap management is not. It assumes that change in interest rates immediately affects the RSAs and RSLs by the same quantum which is not always the case in reality. Ignores the time value of money for the cash flows while determining the gap

ALM Strategies
The size of the net interest income can be controlled through defensive or aggressive ALM. The goal of defensive ALM is to insulate the NII from changes in interest rates; that is, to prevent interest rate changes from decreasing or increasing NII. In contrast, aggressive ALM focuses on increasing NII through altering the portfolio of the institution. The success of aggressive ALM depends on the ability to forecast future interest rate changes. However, if interest rate changes do not move the way predicted, this strategy can lead to losses, and hence risky. The focus of the defensive strategy is to insulate the portfolio from interest rate changes, whether the direction of the interest rate movement is upward or downward, predictable or unpredictable.

How much interest rate risk is acceptable?

One of the most difficult decisions that bank managers face is determining the appropriate degree of interest rate risk to assume. At one extreme, referred to as defensive interest rate risk management, the bank would attempt to structure its assets and liabilities in order to eliminate interest rate risk. However, the profitability of a bank that does not take some interest risk would be inadequate. No one has perfect foresight with respect to interest rates. However, high-risk strategies combined with imperfect forecasts of interest rate movements can result in disaster.

Duration Gap Analysis

The deficiencies of traditional gap analysis, especially the focus on accounting income rather than on equity, have encouraged a search for alternative approaches to measuring and managing the interest rate exposure of a financial institution. One such approach is duration gap analysis. Duration may be defined as the weighted average time (measured in years) to receive all cash flows from a financial instrument.

Semi-active Management Strategy: Immunization

Interest risk comprises two risks: price risk and coupon reinvestment risk. Note that price risk and coupon reinvestment risk derived from a change in interest rates have an opposite effect on the investors ending wealth position. Specifically, a rise in market interest rates, will cause an ending price that is below expectations, but the reinvestment of interim cash flow will be at a rate above expectations, so this flow will be above expectations.

Semi-active Management Strategy: Immunization

It is clearly important for say a bond investor with a known holding period to attempt to eliminate these two risks derived from changing interest rates. Eliminating these risks from a bond portfolio is referred to as immunization. A portfolio of investments in bonds is immunized for a holding period if its value at the end of the holding period, regardless of the course of interest rates during the holding period, is as large as it would have been had the interest rate function been constant throughout the holding period.

Duration
Most bonds provide coupon (interest) payments in addition to a final (par) payment at maturity. A measure of the average time prior to receipt of payment is duration. Duration (D) is the weighted average measure of a bonds life, where the various time periods in which the bond generates cash flows are weighted according to the relative sizes of the present values of those flows.

Duration
We could also say that a bond portfolio is immunized from the interest rate risk if the duration of the portfolio is equal to the desired holding period. This kind of immunisation is very useful where a portfolio of bonds is constructed to fund a known liability. Finally, the duration of a portfolio will keep changing with time. Hence, rebalancing of the portfolio on an annual or as needed basis will have to be carried out.

Duration
N (n)(Cn) / (1 + i)n n=1 D = --------------------------N (Cn) / (1 + i)n n=1 Where, N is the life of the bond in years, C is the cash receipt at the end of year n equal to the annual coupon except for the last year, when it is equal to the annual coupon plus the maturity value, and i is the yield-to-maturity. The numerator is the weighted present value of cash receipts, while the denominator is the sum of all these present values, which is equal to the total present value of the bond.

Example of Duration of a Bond

Let us consider a 7 per cent coupon bond (annual interest payments) with three years to maturity that is priced at par (Rs.1000). (1)[ (70)/(1.07)] +(2) [(70)/(1.07)2]+ (3)[(1070)/(1.07)3] D= ---------------------------------------------------------------------70/1.07 + 70/ (1.07)2 + 1070/ (1.07)3 = 2.81 years

Modified Duration
Now that we know how to calculate a bonds duration, we need to know how much its price will change as its yield changes without need to resort to trial-and-error methods. Algebraically, an approximate direct relationship between the duration of a bond and its price volatility for a change in market interest rates is: % change in price = - MD ( BP/100), where MD = modified duration, BP = change in basis points (plus or minus). Further, MD = D / (1 + r/ p), where D = duration (years) r = market yield (decimal) p = interest payments per year (usually two)

Modified Duration
Suppose a bond has a calculated duration of 4.87 years with an interest rate of 7.76 per cent and interest payable semi-annually. The modified duration on these bonds is thus: MD = (4.87) / (1 + 0.0776/2) = 4.87 / 1.0388 = 4.69 So, suppose these bonds are yielding 7.76 per cent to maturity, and rates fall by 50 basis points to 7.26 per cent. The price of the bond should rise by 2.345 per cent as follows: Per cent change in price = - 4.69 (- 50/ 100) = + 2.345 If say initially the bond sells for 1093.75 to yield 7.76 per cent, it will rise to 1,119.40 to yield 7.26 per cent (a 2.345 percent price rise).

Duration Gap
The duration gap is the difference between the durations of a banks assets and liabilities. It is a measure of interest rate sensitivity that helps to explain how changes in interest rates affect the market value of a banks assets and liabilities, and in turn, its net worth. The net worth is the difference between assets and liabilities, i.e. NW = A L. By using duration, we can calculate the theoretical effects of interest rate changes on net worth: NW = A L, where is change in value.

Measurement of Duration Gap

Balance Sheet Duration Liabilities CD, 1 year Debentures, 5 years Total Liabilities Equity Total Rs. Mio 600 300 900 100 1000 Total 1000 4.00 Duration Assets (Years) 1.00 5.00 2.33 Cash Business loans Mortgage loans Rs. Mio 100 400 500 Duration (Years) 0.00 1.25 7.00

Measurement of Duration Gap

In the above case, duration has been calculated for the assets and liabilities in the following manner. It is assumed that CDs as well as Debentures pay interest once only, at maturity. The duration of each of the assets and liabilities is given. Cash has zero duration. Except for zero coupon securities where only a single payment occurs, duration is always less than maturity. The duration of the CDs and Debentures are the same as their maturities, because they are single payment liabilities.

Measurement of Duration Gap

The duration gap (DGAP) is measured as follows: DGAP = Da WDL, where Da = Average duration of assets, DL = Average duration of liabilities, and W = Ratio of total liabilities to total assets. Thus, DGAP = 4.0 (0.9)(2.33) = 4.00 2.10 = 1.90 yrs. Further, to arrive at an approximation for the expected change in the market value of the equity relative to total assets (TA): Net Worth/ TA - DGAP[ i/(1+i)] or for Rs. Change in net worth: Rs. net worth - DGAP [ i/(1+i)] x TA Suppose that current interest rates are 11% and are expected to increase by 100 basis points. Then % Net Worth (-1.90)(1/1.11) -1.70% In Rs. terms, Rs. Net Worth (-1.90)(1/1.11) x TA -1.7% x Rs.1000 mio = - Rs.17 mio.

Duration Gap Management

If the duration gap is positive (i.e. the duration of assets exceeds the duration of liabilities), then increases in interest rates will reduce the value of net worth, and decreases in interest rates will increase the value the value of net worth. Conversely, if the duration gap is negative, with the duration of assets less than the duration of liabilities, rising interest rates will increase the value of net worth, whereas falling interest rates will lead to a reduction. If the institution is immunised from changes in interest rates through a zero duration gap, changes in the value of assets will be exactly offset by changes in the value of liabilities.

Duration Gap, Interest Rates, and Changes in Net Worth

Duration Gap Positive Positive Negative Negative Zero Zero Change in Interest Change in Net Rates Worth Increase Decrease Increase Decrease Increase Decrease Decrease Increase Increase Decrease No change No change

Duration Gap Management

An aggressive interest rate risk management strategy would alter the duration gap in anticipation of changes in interest rates. For example, if interest rates are expected to increase, management would want to shift from a positive to a negative position. It could do this by reducing the duration of assets and/or increasing the duration of liabilities. The expectation of falling interest rates would produce the opposite type of portfolio management adjustments. Defensive interest rate risk management would seek to keep the duration of assets equal to the duration of liabilities, thereby maintaining a duration gap of zero.

Problems of Duration Gap Management

Immunisation will be effective only if interest rates for all maturity securities shift up or down by exactly the same amount (i.e. only if the yield curve moves upward or downward by a constant percentage amount). In fact, yield curves seldom move in this way. In periods of rising interest rates, short term rates usually move up more than long-term rates. Similarly, in periods of falling interest rates short-term interest rates usually fall more than long term rates. Further, the price changes that occur in the value of a financial asset due to interest changes is only an approximation.

Duration Drift
Another issue is the problem of duration drift. For example, let us presume that a financial institution finances a long term loan (seven year duration) with a maximum of five- and ten-year duration deposits. After say three years the duration of the liabilities has declined more than duration of assets. This happens because maturities were not matched initially even though durations were. This raises the issue of how often one should rebalance the portfolio, as such rebalances are often costly.

ALM Implementation
The consolidated data of the past, future projections, macro-level trends and forecasts will have to be generated at the corporate office. Detailed internal control systems have to be laid down to ensure adherence to the policy framework. Necessary hardware and software have to be in place. As banks become familiar with the techniques and MIS improves, the banks are expected to move over to more sophisticated and data intensive methods of ALM. The end result should be a smooth integration of the risk management process with the banks business strategies.

Simulation and ALM

Banks in advanced countries have started using simulation models that allow them to examine alternative interest rate scenarios, and to stress-test their portfolios. Many of the larger banks depend primarily on simulations, and they set limits for their interest rate exposure. For example, a bank may limit its interest rate exposure to a 5 per cent change in net interest income. Given this limit, it models the balance sheet that will constrain it to that limit when interest rate changes by, say 200 basis points. Stress testing reveals the effects on income and capital of larger changes in interest rates. Stress testing can be thought of as testing the implications of a worst-case scenario.

ALM by Banks
AD Category - I banks may use the following instruments to hedge their asset-liability portfolio : Interest Rate Swaps, Currency Swaps, and Forward Rate Agreements. Recently Interest Rate Futures (IRFs) have been introduced. AD Category - I banks may also purchase call or put options to hedge their cross currency proprietary trading positions. b) The use of these instruments is subject to the following conditions: (i) An appropriate policy in this regard is approved by their Top Management. (ii) The value and maturity of the hedge should not exceed that of the underlying. (iii) No stand alone transactions can be initiated. (iv) The net cash flows arising out of these transactions are booked as income and expenditure and reckoned as exchange position wherever applicable.