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Asset Liability Management

Asset Liability Management. Pre-Financial Sector Reforms (1991). Geographical spread of Bank branches Directed Investments / Credit Programs Administered Rates of Interest Accrual based accounting Problems of Recovery of Loans Deterioration in Quality of Assets /Loans Erosion of Profits

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Asset Liability Management

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  1. Asset Liability Management

  2. Pre-Financial Sector Reforms (1991) • Geographical spread of Bank branches • Directed Investments / Credit Programs • Administered Rates of Interest • Accrual based accounting • Problems of Recovery of Loans • Deterioration in Quality of Assets /Loans • Erosion of Profits • No Computerisation • Trade Union Issues ALM 2008

  3. Banking Reforms 1993 onwards • L-P-G Policy of GOI since 1991 • Technological Changes – ATMs / Internet • New Products and Services : Competition • Narasimham Committee - I / II on Financial / Banking Sector Reforms (1991 & 1997) • Capital Adequacy Ratio : IRAC Norms : NPAs • Priority Sector Loans: Reduce from 40 to 10%? • Reduce SLR (40%) and CRR (15%) • Benchmark Prime Lending Rates • Enactment / Amendments to various laws ALM 2008

  4. Banking Sector Reforms ……. • Market determined Rates of Interest • No directed lending or investments • Organisational Changes : Transparency • 4 way classification of Loan Accounts / Assets • Provisioning for Losses o/a NPAs & Std Assets • ALM (1999) and Risk Management, KYC in Banks • Non Performing Assets definition revised from 4 quarters (1993) dues in Principal & Interest to 3 (1994) to 2 (1995) quarters and now from April 01, 2004 – just 90 days / 1 quarter ! • Basel II norms for Bank Supervision from 2008! ALM 2008

  5. Banks Economic Factors Economic Policies ALM - Introduction ALM 2008

  6. ALM 2008

  7. ALM 2008

  8. ALM 2008

  9. Risks • Various Risks • Interest Rate Risk • Foreign Exchange Risk • Liquidity Risk • Credit Risk • Contingency Risk ALM 2008

  10. Liquidity Risk Profile of a Bank(Rs in crores) ALM 2008

  11. International Initiatives in Managing Risks • Till the 1980s, a professional risk manager was unheard of • Late 1980s, US Financial Firms started using VaR • Basel I ;1988 • Risk Metrics, 1995 • Bank for International Settlement (BIS) - a series of risk management guidelines for Banks worldwide • Market Risk Guidelines of Basel, 1996 • Basel II process ( November 2005 Document) ALM 2008

  12. Risk Management • How to bring it (Risks) down to manageable levels? • The 5-step process • Identification of risks • Quantification • Policy formulation • Strategy formulation • Monitoring ALM 2008

  13. WHAT IS ALM? • An attempt to match: Assets and Liabilities • In terms of: Maturities and Interest Rates Sensitivities • To minimize: Interest Rate Risk and Liquidity Risk ALM 2008

  14. Asset Management Liability Management Asset Liability Management How easily can the Bank generate loans from market How Liquid are the assets of the Bank ALM 2008

  15. Asset Liability Management • ALM is an integral part of the financial management process of any bank. • ALM is concerned with strategic balance sheet management involving risks caused by changes in the interest rates, exchange rates and the liquidity position of the bank.

  16. Asset Liability Management • ALM can be termed as a risk management technique designed to earn an adequate return while maintaining a comfortable surplus of assets beyond liabilities. • It takes into consideration interest rates, earning power, and degree of willingness to take on debt and hence is also known as Surplus Management ALM 2008

  17. ALM and NIM • ALM is all about efficient management of balance sheet dynamics with regard to its size, constituents and quality. • It is the process of managing the Net Interest Margin (NIM) within the overall risk bearing ability of a bank • ALM process depends on the understanding of the balance sheet; the availability, accuracy, adequacy and expediency of the data and the MIS system ALM 2008

  18. GAP Analysis • One way to measure the direction and extent of asset-liability mismatch is by using gap analysis. The analysis derives its name from the “gap” which is the difference between the amounts of Rate Sensitive Asset (RSA) and Rate Sensitive Liabilities (RSL). ALM 2008

  19. HISTORY OF ALM • Mid 1970s in the U.S.A. Deregulation of Interest Rates Interest Rate Risk Liquidity Risk Credit Risk ALM 2008

  20. Definition of ALM • ALM is defined as, “the process of decision – making to control risks of existence, stability and growth of a system through the dynamic balances of its assets and liabilities.” • The text book definition of ALM is “a risk management technique designed to earn an adequate return while maintaining a comfortable surplus of assets beyond liabilities. It takes into consideration interest rates, earning power and degree of willingness to take on debt. It is also called surplus- management”. ALM 2008

  21. SUCCESS OF ALM PROCESS • The ALM process rests on Three Pillars: • ALM Information Systems • ALM Organisation • ALM Process ALM 2008

  22. 1. ALM INFORMATION SYSTEM • Decision Support and Reporting Tool • Comparison between different Branches • Product Analysis • Duration Gap Analysis • Risk Planning and Management • Flexible Design • Strategic Planning of the Asset-Liability Mix • Simulation Analysis • Transfer- Pricing Mechanism ALM 2008

  23. 2. ALM ORGANISATION • Strong Commitment of Senior Management • ALCO should comprise the Senior Management ( including the CEO) • A Support Group of Operational Staff ALM 2008

  24. Board of Directors Management Committee Asset Liability Committee (ALCO) Asset Liability Management Cell Finance Planning Department Credit Analysis Department Credit Risk Management Department Treasury Investment and Loan Departments ALM 2008

  25. ALM 2008

  26. ALM 2008

  27. 3. ALM PROCESS • The scope of ALM function can be described as follows: • Liquidity Risk Management • Management of Market Risks • Trading Risk Management • Funding and Capital Planning • Profit Planning and Growth Projection ALM 2008

  28. Price Matching (Rs. cr.) * Average cost/return on liabilities/assets. ALM 2008

  29. Maturity Matching(Rs. cr.) (period in months) ALM 2008

  30. Risks in ALM • Interest Rate Risk: It is the risk of having a negative impact on a bank’s future earnings and on the market value of its equity due to changes in interest rates. • Liquidity Risk: It is the risk of having insufficient liquid assets to meet the liabilities at a given time. • Forex Risk: It is the risk of having lossesin foreign exchange assets and liabilities due to exchanges in exchange rates among multi-currencies under consideration. ALM 2008

  31. MANAGEMENT OF LIQUIDITY RISK • Availability of funds as & when liabilities are due • Liquidity through maturity & cash flow matching • Maturity ladder & calculation of cumulative surplus/deficits at selected dates ALM 2008

  32. MANAGEMENT OF LIQUIDITY RISK Construction of time buckets: 1 to 30/31 days Over 1 month and upto 2 months Over 2 months and upto 3 months Over 3 months and upto 6 months Over 6 months and upto 1 year Over 1 year and upto 3 years Over 3 years and upto 5 years Over 5 years ALM 2008

  33. MANAGEMENT OF LIQUIDITY RISK • Main focus on Short Term mismatches • Mismatches during 1-30 days < 20 % of cash outflows in the same bucket • For higher limits, special sanction from the Board • Statement of Structural Liquidity (maturity ladder) ALM 2008

  34. MANAGEMENT OF Interest Rate Risk • Impact on Net Interest Income (NII) • Long term impact on market value/ net worth • Techniques: • Gap Analysis • Duration Gap Analysis • Simulation • Value at Risk ALM 2008

  35. 1. GAP ANALYSIS • Calculating Gap over different time intervals at a given date • Mismatches between RSL and RSA • GAP = RSA( i) - RSL( i) = NII( i) for each time bucket • Positive GAP ( RSA > RSL ) • Increasing Interest Rates would be beneficial for a Bank • Negative GAP ( RSL > RSA ) • Falling Interest Rates would be beneficial for a Bank ALM 2008

  36. 9. Control Framework 1. Strategic Framework 8. Regulatory Compliance Framework 2. Organizational Framework ASSET AND LIABILITY MANAGEMENT 7. Performance Measurement Framework 3. Operational Framework 4. Analytical Framework 6. Information Reporting Framework 5. Technology Framework ALM 2008

  37. Gap Analysis • Simple maturity/re-pricing Schedules can be used to generate simple indicators of interest rate risk sensitivity of both earnings and economic value to changing interest rates - If a negative gap occurs (RSA<RSL) in given time band, an increase in market interest rates could cause a decline in NII - conversely, a positive gap (RSA>RSL) in a given time band, an decrease in market interest rates could cause a decline in NII • 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.

  38. Duration Analysis • It basically refers to the average life of the asset or the liability • It is the weighted average time to maturity of all the preset values of cash flows • 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.

  39. Simulation • Basically simulation models utilize computer power to provide what if scenarios, for example: What if: • The absolute level of interest rates shift • 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 this method and improves the quality of information available to the management

  40. Value at Risk (VaR) • Refers to the maximum expected loss that a bank can suffer in market value or income: • Over a given time horizon, • Under normal market conditions, • At a given level or certainty • It enables the calculation of market risk of a portfolio for which no historical data exists. VaR serves as Information Reporting to stakeholders • 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

  41. Regulatory Environment – Risk Management Guidelines in India • ALM Guidelines - February,1999 • Operating Guidelines on Risk Management, October 7, 1999 covering broad contours for management of credit, liquidity, interest rate, foreign exchange and operational risks. • December 2000 : Capital Adequacy Guidelines for Primary Dealers covering Credit and Market Risk • On September 20, 2001, two Working Groups were constituted in Reserve Bank of India drawing experts from select banks and FIs for preparing detailed Guidance Notes on Credit Risk and Market Risk Management by banks. ALM 2008

  42. Risk Regulation in India • Identified further steps to be taken by banks for improving their existing risk management framework, suiting to Indian conditions • 2005 – Detailed Capital Adequacy guidelines for Banks to move towards Basel II, 2007- final guidelines • 2006 – April 17, the ALM framework of 1999 updated. • 2007- Pillar II guidelines being issued ALM 2008

  43. RBI revised guidelines 2007-08 • Issued on Sept 05, 2007 • Feb 10, 1999 guidelines covered Interest Rate and Liquidity Risk Management • Cumulative mis-matches in first bucket to be reported in Statement of Structural Liquidity • -ve Gap in 1-14 and 15-28 days buckets not to exceed 20 % of the cash flows • Need for revising this position – Hence revised the first bucket to 1, 2-7 & 8-14 days ALM 2008

  44. RBI Revised ALM • Cumulative negative mismatches / Gap in new buckets – Next day, 2-7, 8-14 and 15-28 days not to exceed 5, 10, 15 and 20 % respectively of cash flow • Format of Statement of Structural Liquidity has been revised accordingly • Guidance instructions have been furnished • Banks given time to fine-tune MIS by 1 Jan’08 • Reporting frequency to continue as monthly • Supervision will be fortnightly – April 01,2008 • Financing of gaps above norms to be indicated ALM 2008

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