Presentation by S P Dhal, Faculty Member, SPBT College

1. Asset Liability Management in Banks [Module A] Live Interactive Learning Session- 16-04-2007 Presentation by S P Dhal, Faculty Member, SPBT College

2. Components of a Bank Balance sheet Contingent Liabilities

3. Components of Liabilities • 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.

4. Components of Liabilities 2. Reserves & Surplus Components under this head includes: I. Statutory Reserves • Capital Reserves • Share Premium III. Revenue and Other Reserves IV. Balance in Profit and Loss Account

5. Components of Liabilities 3. 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: I. Demand Deposits II. Savings Bank Deposits III. Term Deposits

6. Components of Liabilities 4. Borrowings (Borrowings include Refinance / Borrowings from RBI, Inter-bank & other institutions) I. Borrowings in India i) Reserve Bank of India ii) Other Banks iii) Other Institutions & Agencies II. Borrowings outside India

7. Components of Liabilities 5. Other Liabilities & Provisions It is grouped as under: 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 income tax, TDS, Interest Tax, Provisions etc.)

8. Components of Assets • Cash & Bank Balances with RBI I. Cash in hand (including foreign currency notes) II. Balances with Reserve Bank of India In Current Accounts In Other Accounts

9. Components of Assets 2. BALANCES WITH BANKS AND MONEY AT CALL & SHORT NOTICE I. In India i) Balances with Banks a) In Current Accounts   b) In Other Deposit Accounts ii) Money at Call and Short Notice a) With Banks   b) With Other Institutions II. Outside India a) In Current Accounts b) In Other Deposit Accounts c) Money at Call & Short Notice

10. Components of Assets 3. Investments A major asset item in the bank’s balance sheet. Reflected under 6 buckets as under: I. 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.) II. Investments outside India in ** Subsidiaries and/or Associates abroad

11. Components of Assets 4. Advances The most important assets for a bank. 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

12. Components of Assets 5. Fixed Asset I. Premises II. Other Fixed Assets (Including furniture and fixtures) 6. Other Assets I.Interest accrued   II. Tax paid in advance / tax deducted at source (Net of Provisions)   III. Stationery and Stamps   IV. Non-banking assets acquired in satisfaction of claims   V. Deferred Tax Asset (Net)  VI. Others

13. Contingent Liability Bank’s obligations under LCs, Guarantees, Acceptances on behalf of constituents and Bills accepted by the bank are reflected under this heads. It also includes Un-called part of Partly Paid Investment.

14. Banks Profit & Loss Account A bank’s profit & Loss Account has the following components: • Income: This includes Interest Income and Other Income. II. Expenses: This includes Interest Expended, Operating Expenses and Provisions & contingencies.

15. Components of Income • INTEREST EARNED I. Interest/Discount on Advances / Bills  II. Income on Investments  III. Interest on balances with Reserve Bank of India and other inter-bank funds  IV. Others

16. Components of Income 2. OTHER INCOME I. Commission, Exchange and Brokerage II. Profit on sale of Investments (Net) III. Profit/(Loss) on Revaluation of Investments IV. Profit on sale of land, buildings and other assets (Net) V. Profit on exchange transactions (Net) VI. Income earned by way of dividends etc. from subsidiaries and Associates abroad/in India VII. Miscellaneous Income

17. Components of Expenses • INTEREST EXPENDED I. Interest on Deposits II. Interest on Reserve Bank of India / Inter-Bank borrowings III. Others

18. Components of Expenses 2. OPERATING EXPENSES I. Payments to and Provisions for employees II. Rent, Taxes and Lighting  III. Printing and Stationery IV. Advertisement and Publicity  V. Depreciation on Bank's property VI. Directors' Fees, Allowances and Expenses  VII. Auditors' Fees and Expenses (including Branch Auditors)  VIII. Law Charges   IX. Postages, Telegrams, Telephones etc.   X. Repairs and Maintenance   XI. Insurance  XII. Other Expenditure

19. Provisions & Contingencies • Provision Made for: - Bad & Doubtful debts - Taxation - Depreciation/Diminution in value of Investment - Other Provisions

20. ALM Assets Liability Management It is a dynamic process of Planning, Organizing & Controlling of Assets & Liabilities- their volumes, mixes, maturities, yields and costs in order to maintain liquidity and NII.

21. Financial Intermediation-Qualitative Asset Transformation • Liquidity and payment intermediation • Liquid deposits vs illiquid credits • Maturity intermediation • Short-term deposits vs long-term credits • Denomination intermediation • Small-denomination deposits vs large credits • Diversification intermediation • Investors have a claim against a well-diversified portfolio • Information intermediation • FIs acquire information about the borrowers, provide them with funds, and monitor their performance • Incentives for monitoring: rents or reputation

22. Significance ofALM • Volatility • Product Innovations & Complexities • Integration of Markets • Regulatory Environment • Management Recognition

23. Purpose & Objective of ALM 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. It is aimed to stabilize short-term profits, long-term earnings and long-term substance of the bank. The parameters for stabilizing ALM system are: 1. Net Interest Income (NII) 2. Net Interest Margin (NIM) 3. Economic Equity Ratio

24. RBIDIRECTIVES • Issued draft guidelines on 10th Sept 1998. • Final guidelines issued on 10th Feb’99 for implementation of ALM w.e.f. 01.04.99. • To begin with 60% of asset & liabilities are covered; 100% from 01.04.2000. • Initially Gap Analysis was applied in the first stage of implementation. • Disclosure to Balance Sheet on maturity pattern on Deposits, Borrowings, Investment & Advances w.e.f. 31.03.01

25. Liquidity Management Bank’s liquidity management is the process of generating funds to meet contractual or relationship obligations at reasonable prices at all times. New loan demands, existing commitments, and deposit withdrawals are the basic contractual or relationship obligations that a bank must meet.

26. Adequacy of liquidity position for a bank Analysis of following factors throw light on a bank’s adequacy of liquidity position: • Historical Funding requirement • Current liquidity position • Anticipated future funding needs • Sources of funds • Options for reducing funding needs • Present and anticipated asset quality • Present and future earning capacity and h. Present and planned capital position

27. Factors that may affect a bank’s liquidity include: • A decline in earnings • An increase in Non-Performing assets • Deposit concentration • A down grading by Rating Agencies • Expanded Business Opportunity • Acquisitions • New Tax initiatives

28. Funding Avenues To satisfy funding needs, a bank must perform one or a combination of the following: • Dispose off liquid assets • Increase short term borrowings • Decrease holding of less liquid assets • Increase liability of a term nature • Securitization of Assets f. Increase Capital funds

29. 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

30. Other categories of liquidity risk • Funding Risk - Need to replace net outflows due to unanticipated withdrawals/non-renewal Arises due to: • Fraud Causing substantial loss • Systemic risk • Loss of Confidence • Liabilities in Foreign Currencies

31. Other categories of liquidity risk • Time Risk - Need to compensate for non-receipt of expected inflows of funds Arises due to: - Severe deterioration in asset quality - Standard assets turning into NPA - Temporary Problem in recovery - Time involved in managing liquidity

32. Other categories of liquidity risk • Call Risk • Crystallization of contingent liability Arises due to: • Conversion of non-fund based limit to fund based limit • Swaps and Options

33. Measuring & Managing Liquidity Risk Steps necessary for managing liquidity risks in Banks • Developing a structure for managing liquidity risk • Setting tolerance level and limit for liquidity risk • Measuring and Managing Liquidity Risk

34. Setting tolerance level and limit for liquidity risk Limits could be set on the following lines: • Cumulative cash flow mismatches over particular period taking conservative view of marketable liquid assets • Liquid assets as percentage of short-term liabilities • A limit on Loan to deposit ratio • A limit on loan to capital ratio • Primary sources for meeting funding needs should be quantified • Flexible liquidity provision to be maintained to sustain operations

35. Measuring and Managing Liquidity Risk Measuring and Managing funding requirement can be done through two approaches: • Stock Approach • Flow Approach

36. Stock Approach This Approach is based on the level of assets and liabilities as well as Off-Balance sheet exposures on a particular date. • Ratio of Core Deposit to total Assets: Core Deposit/Total Asset: More the ratio better it is because core deposit treated to be the stable source of liquidity. • Net Loans to Total deposits Ratio: Net Loans/Total Deposit: It reflects the ratio of loans to Public Deposits or core deposits. Lower the ratio is the better.

37. Stock Approach • Ratio of Time Deposit to Total Deposits: Time Deposits/Total Deposits: Higher the Ratio better • Ratio of Volatile liabilities to total assets Volatile Liabilities/Total Assets Lower the Ratio the Better • Ratio of Short Term Liabilities to Liquid Assets: Short Term Liabilities/Liquid Assets: Lower the Ratio the better

38. Stock Approach • Ratio of Liquid Assets to Total Assets: Higher the Ratio the better • Ratio of Short Term Liability/Total Assets: A lower ratio is desirable • Ratio of Prime Asset to Total Asset: Higher the ratio the better • Ratio of Marketable liability to total asset: Lower the ratio better N.B>Indian Banks do not follow this approach

39. Flow Approach The Frame work for assessing and managing bank liquidity through flow approach has three major dimensions: • Measuring and Managing net funding requirements • Managing market access, and • Contingency Planning

40. Statement of Structural Liquidity All Assets & Liabilities to be reported as per their maturity profile into 8 maturity Buckets: • 1 to 14 days • 15 to 28 days • 29 days and up to 3 months • Over 3 months and up to 6 months • Over 6 months and up to 1 year • Over 1 year and up to 3 years • Over 3 years and up to 5 years • Over 5 years

41. STATEMENT OF STRUCTURAL LIQUIDITY • Places all cash inflows and outflows in the maturity ladder as per residual maturity • Maturing Liability: cash outflow • Maturing Assets : Cash Inflow • Classified in to 8 time buckets • Mismatches in the first two buckets not to exceed 20% of outflows • Shows the structure as of a particular date • Banks can fix higher tolerance level for other maturity buckets.

42. An Example of Structural Liquidity Statement

43. ADDRESSING THE MISMATCHES • Mismatches can be positive or negative • Positive Mismatch: M.A.>M.L. and Negative Mismatch M.L.>M.A. • In case of +ve mismatch, excess liquidity can be deployed in money market instruments, creating new assets & investment swaps etc. • For –ve mismatch,it can be financed from market borrowings (Call/Term), Bills rediscounting, Repos & deployment of foreign currency converted into rupee.

44. STRATEGIES… • 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 years maturities and invest it in securities of 1-29 days of Rs 200 crores and rest matching with other out flows.

45. Liability/Assets Rupees (In Cr) In Percentage I. Deposits a. Up to 1 year b. Over 1 yr to 3 yrs c. Over 3 yrs to 5 yrs d. Over 5 years 15200 8000 6700 230 270 100 52.63 44.08 1.51 1.78 II. Borrowings a. Up to 1 year b. Over 1 yr to 3 yrs c. Over 3 yrs to 5 yrs d. Over 5 years 450 180 00 150 120 100 40.00 0.00 33.33 26.67 III. Loans & Advances a. Up to 1 year b. Over 1 yr to 3 yrs c. Over 3 yrs to 5 yrs d. Over 5 years 8800 3400 3000 400 2000 100 38.64 34.09 4.55 22.72 Iv. Investment a. Up to 1 year b. Over 1 yr to 3 yrs c. Over 3 yrs to 5 yrs d. Over 5 years 5800 1300 300 900 3300 100 22.41 5.17 15.52 56.90 Maturity Pattern of Select Assets & Liabilities of A Bank

46. Interest Rate Sensitivity Analysis • Structural Liquidity Statement is the basis for IRS analysis. All off balance sheet items are excluded except Repos, Reverse Repos and SWAPs. • Non-sensitive assets / liabilities are shifted to non-sensitive bucket (like Capital, Reserves, Fixed Assets etc). • A perception of likely interest rate scenario is formed. Accordingly, re-pricing effect is assessed for all RSA / RSL. • Rate sensitive gaps are assessed from the analysis.

47. STATEMENT OF INTEREST RATE SENSITIVITY • Generated by grouping RSA,RSL & OFF-Balance sheet items in to various (8)time buckets. RSA: • MONEY AT CALL • ADVANCES ( BPLR LINKED ) • INVESTMENT RSL • DEPOSITS EXCLUDING CD • BORROWINGS

50. MATURITY GAP METHOD(IRS) • THREE OPTIONS: • A) RSA>RSL= Positive Gap • B) RSL>RSA= Negative Gap • C) RSL=RSA= Zero Gap