Asset liability management in banks

1

Sr. No.ParticularsPage No.

1.Introduction1

2.Earlier Phase

3.Asset/Liability Management Strategy

4.Pricing

5.Terms of ALM Policy

6.ALM Models

7.ALM Organisation

8.ALM Process

9.Scope of ALM

10.Implementation Issues

11.Guidelines of ALM in Banks

12.Emerging Issues in Indian Context

13.Challenges faced by ALM

14.Conclusion

15.Bibliography

IndexINTRODUCTIONIn banking, asset and liability management (often abbreviated ALM) is the practice of

Managing risks that arise due to mismatches between the assets and liabilities (debts and assets) of the bank. This can also be seen in insurance.

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 of the duration, by hedging and by securitization. Much of the techniques for hedging stem from the delta hedging concepts introduced in the BlackScholes model and in the work of Robert C. Merton and Robert A. Jarrow. 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. Van Deventer, Imai and Mesler (2004), chapter 2, outline this history in detail.

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. The Jarrow-Turnbull model is an example of a risk management methodology that integrates default and random interest rates. The earliest work in this regard was done by Robert C. Merton. Increasing integrated risk management is done on a full mark to market basis rather than the accounting basis that was at the heart of the first interest rate sensivity gap and duration calculations.

Asset Liability Management (ALM) defines management of all assets and liabilities (both off and on balance sheet items) of a bank. It requires assessment of various types of risks and altering the asset liability portfolio to manage risk. Till the early 1990s, the RBI did the realbanking business and commercial banks were mere executors of what RBI decided. But now, BIS is standardizing the practices of banks across the globe and India is part of this process. The success of ALM, Risk Management and Basel Accord introduced by BIS depends on the efficiency of the management of assets and liabilities. Hence these days without proper management of assets and liabilities, the survival is at stake. A banks liabilities include deposits, borrowings and capital. On the other side of the balance sheets are assets which are loans of various types which banks make to the customer for various purposes. To view the two sides of banks balance sheet as completely integrated units has an intuitive appeal. But the nature, profitability and risk of constituents of both sides should be similar. The structure of banks balance sheet has direct implications on profitability of banks especially in terms of Net Interest Margin (NIM). So it is absolute necessary to maintain compatible asset-liability structure to maintain liquidity, improve profitability and manage risk under acceptable limits.

Liquidity management is a provoking idea for the management of the financial institutions to ponder about and act. But how to act and when to act are the questions which lead to Assets and Liability Management (ALM), a management tool to monitor and manage various aspects of risks associated with the balance sheet management, including the management and balance sheet exposure of the institutions. In other words, ALM is an ongoing process of formulating, monitoring, revising and framing strategies related to assets and liabilities in an attempt to achieve the financial objective of maximizing interest spread or margins for a

given set of risk level. It is not only a liquidity management tool, but also a portfolio

Management tool to alter the composition of assets and liability portfolio to manage the risk by using various risk mitigating measures. Assets/liability management is an integral part of the planning process of commercial banks. In fact, asset/liability management may be considered as one of the three principal components of a planning system. The three components are:

Asset/liability management which focuses primarily on the day-to-day or week-to-week balance sheet management necessary to achieve short term financial goals.

Annual profit planning and controls which focus on slightly longer term goals and look at a detailed financial plan over the course of a fiscal or calendar year. Strategic planning which focuses on the long run financial and non financial aspects of a banks performance.

EARLIER PHASE

In the 1940s and the 1950s, there was an abundance of funds in banks in the form of

demand and savings deposits. Because of the low cost of deposits, banks had to develop mechanisms by which they could make efficient use of these funds. Hence, the focus then was mainly on asset management. But as the availability of low cost funds started to decline, liability management became the focus of bank management efforts. The ALM, historically, has evolved from the early practice of managing liquidity on the banks asset side, to a later shift to the liability side and termed liability management, to a still later realization of using both the assets as well as the liabilities side of the balance sheet to achieve optimum resources management, i.e., an integrated approach. Prior to deregulation, bank funds were

obtained from relatively stable demand deposits and from small time deposits. Interest rate ceiling limited the extent to which banks could compete for funds. Opening more branches in order to attract fresh deposits. As a result, most sources of funds were core deposits which were quite impervious to interest rate movements in this environment bank fund management concentrate on the control of assets.

he banks ability to grow will be hampered if they do not have access to the funds required to create assets. They have freedom to obtain funds by borrowing from both the domestic and international markets. As they tap different source of funds, there is an increased need for liability management and it becomes an important part of their financial management. With liability management, banks now have two sources of funds core deposits and purchased funds with quite different characteristics. For core deposits, the volume of funds is relatively insensitive to changes in interest rate levels.. However core deposits have the disadvantage of not being overly responsive to management needs for expansion. If a bank experiences sizeable increase in loan demand, it cannot expect the core deposits to increase proportionately. For purchased funds, however, the bank can obtain all the funds

that it wants if it is willing to pay the market determined price. Unlike core deposits where the bank determines the price, the interest rates on purchased funds are set in the national money market. The bank can be thought of as a price taker in the purchased funds market whereas in the core deposit market it can be viewed as a price setter. The purchased funds give complete flexibility in terms of the volumes and timing of the availability of funds. management, the core deposits offer the advantage of stability. However core deposits have the disadvantage of not being overly responsive to management needs for expansion. If a bank experiences sizeable increase in loan demand, it cannot expect the core deposits to increase proportionately. For purchased funds, however, the bank can obtain all the funds that it wants if it is willing to pay the market determined price. Unlike core deposits where the bank determines the price, the interest rates on purchased funds are set in the national money market. MODERN PERSPECTIVE

The recent volatility of interest rates broadened to include the issue of credit risk and market risk and to ensure that their risk management capabilities are commensurate with the risk of their business. The induction of credit risk into the issue of determining adequacy of bank capital further enlarged the scope of ALM. .According to policy approach of Basel II in India, to conform to best international standards and in the process emphasis is on harmonization with the international best practices. If this were so, the scope and the role of ALM become all the more enlarged. Incidentally, commercial banks in India will start implementing Basel II with effect from March 31, 2008 though, as indicated by the governor of the RBI, a marginal stretching beyond this date can not be ruled out in view of latest indications of the state of preparedness. In current spell, earning a proper return for the promoter of equity and maximization of its market value means management of the balance sheet of the institution. In other words, this also implies that managements are now expected to target required profit levels and ensure minimization of risks to acceptable levels, to retain the interest of the investing community. In todays competitive environment, if the organization has to remain in the business, costing and product pricing policies have to be suitably structured. Thus, with the changing requirement, there is a need for not only managing the net interest margin of the organization but at the same time ensuring that liquidity is managed, how much liquid the organization has to be definitely, worked out on the basis of scenario analysis, but the knowledge to management, adopt the new system and organizational changes that are called for it to manage, have to be defined. Thus, the concept of ALM is much wider and is of greater significance

COMPONENTS OF BANKS BALANCE SHEET

This assets and liabilities of a Bank are divided into various sub heads. For the purpose of the study, the assets were regrouped under six major heads and the liabilities were regrouped under four major heads as shown in table below. This classification is guided by prior information on the liquidity-return profile of assets and the maturity-cost profile of liabilities. The reclassified assets and liabilities covered in the study exclude other assets on the asset side and other liabilities on the liabilities side. This is necessary to deal with the problem of singularity a situation that produces perfect correlation within sets and makes correlation between sets meaningless.

Banks Liabilities:

Capital

Reserve and Surplus

Deposits

Borrowings

Other Liabilities & Pro.

Contingent Liabilities

Banks Assets:

Cash and Balance with RBI

Balance with other banks

Investment

Advances

Fixed assets

Other assets BALANCE SHEET MIX

ALM policy should establish portfolio limits on the mix of balance sheet liabilities such as deposits and other types of funding, as a percentage of total assets, considering the differential costs and volatility of these types of funds. Similarly, prudent portfolio limits on the mix of balance sheet assets (e.g. loans by credit category, financial instruments, etc.) should be set by policy considering differential levels of risk and return. his recommended practice may not be practical for smaller, less complex credit unions which have a limited membership base, a simple balance sheet without much product diversification (e.g. savings and personal loans) or which do not have sufficient financial resources to effectively promote diversification. If this is the case, ALM policy should state that an appropriate mix of deposits and other liabilities will be maintained to reflect member expectations and to correlate (by term and pricing) to the mix of assets held. The mix of assets (loans, investments) return should be guided by annual planning targets, lending license constraints and regulatory restrictions on investments. The management in the bank would like to ensure that beyond the capital planning and ALM teams, the stakeholders in each line of business are able to appreciate the cost of capital required for respective lines of business and how it is impacting the bottom-line ultimately.

Oracle Financial Services Balance Sheet Planning solution helps fulfill the need for

extending ALM income forecasts and Balance Sheet projections into enterprise planning activities, thereby rendering a consistent picture of forecasts across the institution. The integration of planning solutions with the risk and performance management framework is a major milestone in this direction. ASSET MANAGEMENT STRATEGY

Some banks had the traditional deposit base and were also capable of achieving substantial growth rates in deposits by active deposit mobilization drive using their extensive branch network. For such banks the major concern was how to expand the assets securely and profitably. Credit was thus the major key decision area and the investment activity was based on maintaining a statutory liquidity ratio or as a function of liquidity management. The management strategy in such banks was thus more biased towards asset management. this Section provides direction on setting policy constraints on the size and types of loans and investments so as to make the best use of available funds maximize financial margin while maintaining an appropriate level of safety. The assets of a credit union can be

classified into two broad categories: earning assets and non-earning assets. ALM policy should promote the maximization of earning assets which reward the credit union for its operating risks. Earning assets are those assets which generate direct revenues for the credit union.

LIABILITY MANAGEMENT STRATEGY

Some banks on the other hand were unable to achieve retail deposit growth rates since they did not have a wide branch network. But these banks possessed superior asset management skills and hence could fund assets by relying on the wholesale markets using Call money, CDs Bill Rediscounting etc. Deregulation of interest rates coupled with reforms in the money market introduced by the reserve bank provided these banks with the opportunity to compete with funds from the wholesale market using the pricing strategy to achieve the desired volume, mix and cost. So under the Liability management approach, banks primarily sought to achieve maturities and volumes of funds by flexibly changing their bid rates for funds.

OBJECTIVES:

When a bank needs funds to cover deposit withdrawals or ton expand its loans to acquire other assets, it can obtain the needed funds in two ways. One way of acquiring funds is to liquidate some of the short term assets that the bank holds in units liquidity account for this purpose. A bank can also obtain funds by acquiring additional liabilities i.e. by buying the funds it needs. Basically, liability management seeks to control the sources of funds that a bank can obtain quickly and in large amounts, unlike demand and savings deposits, which cannot be increased to any great degree over a short time period. Depending on cost and availability, a bank will use a variety of liability management instruments to obtain the liquidity needed for daily cash management, for loan expansion, and for other earnings opportunities. Liability management provides a bank with an alternative to asset liquidation to obtain needed funds, and the bank chooses between these alternatives based on the relative costs and risks involved. For example: depending on a banks size and on market conditions, a bank in need of liquidity may chose to borrow government funds or issue CDs rather than sell T bills or other liquid assets. Liability management also provides a bank with an alternative to asset management in obtaining the greatest value from inflows of funds. therefore a bank which follows both assets and liability management strategies has the option of using cash inflows to obtain more short term liquid assets or to repay outstanding liabilities, depending on which option provides the best combination of earnings and safety.

BENEFITS OF LIABILITY MANAGEMENT:

he key benefit of using Liability Management as a funding strategy is that it provides a bank with an alternative to asset management for short term adjustments of funds. For example: Assume that the bank experiences a sudden and unexpected marked decline in the level of its demand deposits. If the banks only source liquidity is its assets, it must sell some of its securities to obtain the funds needed to cover the run off of its deposits, whether or not market conditions are favorable. With liability management, the bank may be able to raise the needed funds by incurring liabilities, thereby postponing the sale of its assets until conditions are more favourable.Liability management also provides a bank with the means of funding long term growth. It does so by enabling a bank to expand its loans ad other assets by managing its liabilities so that a certain volume of its liabilities remains outstanding at all times so that it can build up on its deposit levels and thereby expand the level of its loans. This approach of funding is normally followed within a context of a long term upswing in the economy in which the borrowers seek more loans for business expansion and depositors place their funds in negotiable time certificates to earn competitive rates. In such cases, bank management must have a clear idea of the level of outstanding liabilities that it can count on holding through tight money periods by offering competitive rates.

Another benefit of liability management is that it allows banks to invest greater percentage of its available funds in its securities that provide less liquidity but offer higher earnings, this is possible because the banks liquidity account doesnt have to bear the full burden of the banks liquidity needs. A bank that has the option of obtaining liquidity through its liabilities has an opportunity to increase profitability because it can reduce the amount of short term assets it holds for liquidity purposes and place those funds into longer term securities that offer less liquidity but offer higher earnings.

RISKS INVOLVED IN LIABILITY MANAGEMENT: Although the use of liability management along with asset management allows a bank the least costly method of obtaining liquidity from a wider range of funding options, but the added options that liability management provides also require greater complexity in planning and executing funds management strategies. This is so since banks can obtain money market deposits and liabilities only by paying market rates and the behaviour of financial markets cannot be predicted with complete accuracy.

Another risk involved is that of issuing long term fixed rate CDs at the peak of the business cycle. This results in more costly CDs in the future with a fall in the interest rates. In fact if short term assets are funded by long term liabilities and rates subsequently decline, a bank may find that it is paying more for funds than it can earn on those funds.

Another risk that relates to the changing market conditions is the stability of the banks sources of borrowed or purchased funds. While large money center banks are usually able to obtain funds under tight money conditions if they are willing to pay market rates, smaller banks may find it impossible to compete for funds when prices are high. The risk that a funding house may prove unreliable is also a real problem for smaller banks that move outside their trading areas or that undertake funding by means of liability instruments with which they are not completely familiar. Such banks face the very real possibility that their sources of funds may disappear just when they are most needed. The basic benefits of liability management lie in the options it provides a bank in obtaining a least costly method of funding given the banks particular needs and the existing conditions of the financial markets. The risk involved in liability management basically results from too much reliance on the use of purchased funds without recognizing the impact that changing market conditions or other unanticipated changes can have on the banks ability to secure

funds when the money is scarce.Non-earning assets should therefore be minimized, i.e. investment in cash, non-accrual loans/investments and capital (e.g. fixed) assets. Under Regulation 76/95, there is a requirement for credit unions to maintain a certain amount of its assets in liquid form. This liquidity need not be held in cash, but can be in the form of callable deposits of a league or a Canadian chartered bank/trust company (see section 16 of Regulation 76/95). Despite the legal flexibility, surplus cash is often left on the premises of a credit union rather than being placed into interest bearing accounts.

Operational procedures should limit the maximum amount of cash left on premises. High teller floats or ATM balances, excessive funds in transit (e.g. balances that are not cleared daily for deposit with the league), or idle cash in non-interest current accounts will increase the amount of non-earning assets and lower financial spread. In the case of teller floats or ATM balances, operational procedures should set maximum limits that can still accommodate members' needs. ADVANTAGES

ALM can help protect a financial institution or corporation against a variety of financial and nonfinancial risks.

he mere process of identifying risks enables businesses to be better prepared to deal with these risks in the most cost-effective way.

ALM ensures that a companys capital and assets are used in the most efficient way.

It can be used as a strategic and business tool to improve earnings.

DISADVANTAGES

ALM is only as good as the people on the ALM committee and the operational procedures that they follow.

ALM can prove costly in terms of both the time required of employees and the investment required in management tools such as IT and techniques such as hedging. ASSET/LIABILITY MANAGEMENT PHILOSOPHY

Adopting an asset/liability management philosophy is an important first step in drafting ALM policy. The philosophy should set out the broad goals and objectives of the credit unions asset/liability portfolio, as established by the board of directors, who represent the membership at large. This philosophy governs all ALM policy constraints and helps address new situations where policy does not yet exist. While goals and objectives will differ depending upon the circumstances and environment of the credit union, the ALM philosophy should always address the following principles:

he credit union will manage its asset cash flows in relation to its liability cash flows in a manner that contributes adequately to earnings and limits the risk to the financial margin.

Product terms, pricing and balance sheet mix must balance members product demands with the need to protect the equity of the credit union.

Financial derivatives instruments must only be used to limit interest rate risk and must never be used for speculative or investment purposes. PRICING

ALM policy specifies that the pricing of all loans and deposits offered should be established so that overall, a net contribution to earnings is provided. In order to ensure that deposit and lending rates are sufficiently responsive, policy may delegate to management the authority to set interest rates without board approval but in accordance with pre-established criteria as described below:

Deposit Pricing Policy:

Rates offered on deposits should be tied to external benchmarks in the local market and should generally approximate the average of these market indicators (for example, the bank rate or the prime rate). Policy should allow management flexibility to negotiate more favorable rates within a prescribed range to maintain key deposit accounts. In order to protect financial margin, credit unions should avoid engaging in price wars with competitor financial institutions including other credit unions. Pricing strategies of competitor institutions will reflect the need for funds in these organizations. Liquidity requirements of the competitor institution may differ vastly from the credit union's needs; therefore, caution should be exercised when setting rates.

Loan Pricing Policy:

It is recommended that loans be priced at market rates and subject to interest rate rebates only at the end of the year, if sufficient earnings and reserves are available. The interest rates offered on loans should reflect an adequate margin above the rates on deposits being used to fund loans, in order to cover all operating expenses and capital requirements. Loan pricing can also be used to balance minor gap mismatches. Where funding from deposits is high for a particular term of loan, the price for these loans could be made more attractive than terms whose funding sources are scarce. For larger gap mismatches, however, a derivative instrument may be a more practical option. Loan pricing is crucial for establishing a successful lending program. In order to establish fair interest rates for both the borrower and the credit union, the following factors should be considered: Cost of funds and the spread required for financing the loan.

Market rates offered by the competition.

Excess liquidity position of the credit union.

Maturity and repayment terms of the loan.

Credit risk of the loan (e.g. loan purpose, size and security).

Length of loan amortization period (generally, the longer the period, the higher the rate).

Share Pricing Policy:

When issuing capital shares, discretionary dividend rates should be subject to ALM policy criteria approved by the board. Dividend rates should be set with due regards to the average cost of alternative funds such as deposits, other classes of shares and borrowings. When stock dividends are offered as an alternative to cash dividends, the future costs of increased fixed dividends should be analyzed for ongoing affordability, before stock dividends are declared.

TERMS OF ALM POLICY

ALM policy should set reasonable limits on the terms of loans and deposits. These limits should be broad enough so that management can set varying terms for individual products in operational procedures based on product purpose, so long as these do not exceed the maximum term limits approved by the board. here are no regulatory requirements for the maximum term on any assets or liabilities which a credit union can assume. Term Deposits:

It is recommended that the board establish maximum term limits on term deposits. Operational procedures can describe the availability of alternative term deposits and correlate differential pricing for these products within this limit. he board may want to set a general five year maximum term on deposits in policy, and require that any products with terms greater than five years require special board approval.

Term Loans:

It is recommended that the board establish maximum term limits on term loans. Operational procedures can describe the availability of alternative term loans and correlate differential pricing for these products within this limit. he board may want to set a general five year maximum term on loans in policy, and require that any products with terms greater than five years require special board approval.

Operational Procedures:

he criteria for offering term loans of varying length can be specified in operational procedures. Operational procedures can require that loan terms be set to similar lengths as the life of the security (e.g. large loans secured by higher valued assets would normally have longer terms to maturity). Due to the higher repayment and security risks of longer term loans, and the usually limited consumer demand for term deposits in excess of five years, it is recommended that generally, term loans be offered with five year maximum maturities.For increased competitiveness, however, loan maturities in excess of five years may occasionally be sanctioned up to a prescribed policy limit or approved by the board on an exception basis.

Mortgage terms of seven to ten years have become more commonplace in the market but generally should only be offered by credit unions if arrangements are in place to manage the gap between five year funding deposits and those longer term mortgages. Credit unions should consult with their league for appropriate strategies prior to offering extended term mortgages. term loans should be substantially matched by contractual maturity dates against non-callable term deposits. For mortgages with terms exceeding one year, selective prepayment penalties should be established by operational policy.

ALM STRATEGY As interest rated in both the liability and the asset side were deregulated, interest rates in various market segments such as call money, CDs and the retail deposit rates turned outdo be variable over a period of time due to competition and the need to keep the bank interest rates in alignment with market rates. Consequently the need to adopt a comprehensive Asset- liability strategy emerged, the key objectives of which were as under.

he volume, mix and cost/return of both liabilities and assets need to be planned and monitored in order to achieve the banks short and long term goals.

Management control would comprehensively embrace all the business segments like deposits, borrowing, credit, investments, and foreign exchange. It should be coordinated and internally consistent so that the spread between the banks earnings from assets and the costs of issuing liabilities can be maximized.

Suitable pricing mechanism covering all products like credit, payments, and custodial financial advisory services should be put in place to cover all costs and risks.STRATEGIC APPROACHES TO ALMSpread Management : his focuses on maintaining an adequate spread between a banks interest expense on liabilities and its interest income on assets.

Gap Management: his focuses on identifying and matching rate sensitive assets and liabilities to achieve maximum profits over the course of interest rate cycles A bank will price the loan even taking the liquidity risk. Incorporating the default probabilities helps the bank to price the loan appropriately in line with its risk profile. Hence bank would also look at the impact of such a loan on its liquidity along with the credit risk and not in isolation. The bank would now have flexibility in accepting and rejecting the loan only after having considered all parameters. It will provide the necessary direction to the bank in structuring the loan in such a way, that liquidity profile of the bank is improved. If the liquidity profile of the portfolio is improved the loan can be priced favorably for the borrower. This model helps us to identify those loans that contribute to the ROA and Roe of the bank. This puts the bank on the road to SHAREHOLDER VALUE CREATION. By identifying the acceptable risk limits, the bank achieves greater stability thus ensuring higher returns for the shareholders. While a similar system might already be in use in several competitive banks in one form or the other, other banks that do not employ such a system in totality might find it useful to adopt the integrated ALM approach which has been presented as a conceptual argument ALM MODELS

Analytical models are very important for ALM analysis and scientific decision-making. The basic models are:

1. GAP Analysis Model

2. Duration GAP Analysis Model 3. Scenario Analysis Model

4. Value at Risk (VaR) model

5. Stochastic Programming Model : Any of these models is being used by banks through their Asset Liability Management Committee (ALCO). The Executive Director and other vital departments heads head ALCO in banks. There are minimum four members and maximum eight members. It is responsible for Responsible for Setting business policies and strategies, Pricing assets and liabilities, Measuring risk, Periodic review, Discussing new products and Reporting. 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 reprising 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. Reprising gaps are calculated for assets and liabilities of differing maturities. A positive gap indicates that assets get reprised before liabilities, whereas, a negative 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. 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 modelling, it makes sense to stick to simpler types of analysis. 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 basic

-ally refers to the average life of the asset or the liability.

DP p = D ( dR /1+R)

he 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:

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.

Simulation:

Simulation models help to introduce a dynamic element in the analysis of interest rate risk. Gap analysis and duration analysis as stand-alone too15 for 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. for 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.

ALM Organization

T he Board of Directors would have the overall responsibility for the ALM & risk management and should lay down the tolerance limits for liquidity and interest rate risk in line with the organizations philosophy. However, the Asset Liability Committee (ALCO) is responsible for deciding on the business strategies consistent with the laid down policies and for operating them. Typically, ALCO consists of the senior management, including the Chief Executive. Needless to say ALCO has to be supported by an efficient analytics providing detailed analysis, forecasts, scenario analysis and recommendation for action. ALCO not only makes business decisions, but also monitors their implementation and their impact. Further, it also takes action and initiates changes in response to the market dynamics. ALCO Support Group will provide the data analysis, forecasts and scenario analysis for ALCO. 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

he size (number of members) of ALCO would depend on the size of each institution, business mix and organizational complexity or ensure commitment of the 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 content of d asset liability management includes: Background & Overview of Asset and Liability Committee (ALCO)

Role & Objectives

Sample Statements on Role / Function of ALCO

Capital of a financial institution

Funding and Liquidity

Structural Market Risk of on and Off Balance Sheet items

Asset / Liability Composition

What comprises Assets?

What comprises Liability?

Detail discussion on characteristics of the major assets and liabilities

Sample Balance Sheet of some local commercial banks

Off Balance-Sheet items Role of ALCO in Capital Management

Minimum Capital Standards and Compliance

Capital Structure of a Banking Institution

Regulatory Capital, Compliance & Maintenance Illustration : Sub-Prime crisis impact on Banks Capital

What would ALCO look at Capital Adequacy

Growth of Assets-Liabilities and adequacy of Capital Role of ALCO in Funding and Liquidity Management

Liquidity Structure and Regulatory Framework

Liquidity Concept and Objectives (MCO, MCI)

Money Market, Liquidity and their significance to Banking Institutions

Regulatory Framework and Compliance

Regulatory Limits, Ratios, Utilization

Liquidity Profile and Associated Risks :

Growth in Asset-Liability Types and implication on Liquidity

Assessment of Change in Liquidity Profile

ALCOs Role, Objectives, Actions GOAL OF COMMITTEE

Management of assets and liability incorporates interest rate risk and liquidity considerations into a bank's operating model. From a regulatory perspective, one of the ALCO's goals is to ensure adequate liquidity while managing the bank's spread between the interest income and interest expense. Investments and operational risk are also major considerations. A sound practice is to conduct ALCO meetings at least quarterly to review the bank's level of exposure to changing interest rates and to determine management's degree of compliance with internal policies and quantitative parameters, such as limits and ratios. ALCO responsibilities include managing market risk tolerances, establishing appropriate MIS, reviewing and approving the liquidity and funds management policy at least annually, approving a contingency funding plan, and reviewing immediate funding needs and sources-possibly engaging an independent third party to validate the assumptions and data contained in internally or externally prepared management reports. ALM PROCESS

The ALM process rests on three pillars: ALM information systems

=> Management Information System

=> Information availability, accuracy, adequacy and expediency ALM organization

=> Structure and responsibilities

=> Level of top management involvement ALM process

=> Risk parameters

=> Risk identification

=> Risk measurement

=> Risk management

=> Risk policies and tolerance levelsASSET-LIABILITY MANAGEMENT AND FINANCIAL GOALS

Credit unions have many financial goals; however, two are basic to their survival: first, earn net income and second, remain solvent, or able to meet demands for cash (such as payment of operating expenses). Earnings allow a credit unions capital to increase, which is necessary for growth. Credit union managers must focus on asset-liability management because fluctuating interest rates, intense competition, consolidation, and member demands for better, more efficient, more convenient products can reduce earnings and, therefore, capital. A credit union must manage its cash flowing into and out of its assets and liabilities and the interest rates related to its financial products. Understanding the characteristics of cash flow is necessary to adequately measure interest- rate risk and stay solvent. RISK MEASUREMENT AND BOARD REPORTING

It is recommended that the credit union measure the performance and risk level of the credit unions asset/liability management activities, and report these findings to the board. Risk Measurement:

The following are minimum risk and performance measures of ALM, required by sound business and financial practices:

Periodic measurement of overall balance sheet mix.

Periodic measurement of asset, liability and capital growth or decline.

Periodic measurement of operational cash flows.

Periodic measurement of financial margin.

Periodic measurement or projection of the impact of interest movements.

Periodic measurement of the level of unhedged foreign currency funds.

Periodic assessment of the appropriateness of financial derivatives held.

The credit union must also meet ALM measurement requirements set out in the Act and Regulations. The credit union may track any other measures of the loan portfolio as it sees fit. these measurements should be compared to financial targets in the annual business plan and the budget, so that management can determine whether the credit union is meeting its goals. Management can also assess whether there are material variances from the plan which need to be addressed.

Risk Management Techniques

Sections 7401 to 7405 provide techniques for measuring and monitoring the adequacy of the credit union's ALM activities.

Board Reports

The above measurements should be reported to the board of directors, so that the board can also monitor ALM activities and ensure adherence to regulatory requirements and to the annual business plan. Material variances from plan, and their causes, as well as management's plan to correct the variance should also be included in the report. Management should also provide the board with a summary on compliance with ALM policy and relevant regulatory requirements.

Credit score of risk in asset liability management

The credit score is the result of the credit appraisal process. It is at this stage that the credit risk is quantified in terms of default probabilities. The interest rate score reflects the spread earned by the corporate bank over and above the transfer price. The liquidity score reflects the impact of the proposal on the liquidity profile of the bank. Every bank would have certain target Gaps. Every proposal either takes the bank away from the target Gap or brings it closer to the same. This score reflects the impact of the proposal on the Gap profile of the bank. The score also is a reflection of the cost of funding the liquidity mismatch that it might create. This looks at the possibility of a credit default. This kind of arrangement, however, demands, diligent monitoring of the asset to keep the bank updated with its liquidity profile.

Asset Evaluation:

Once the three performance scores are available, the entire evaluation of the asset can be condensed to a one-page report. Here the performance measures are graded on a scale of 1-5. The weighted average of these scores will give us the COMPOSITE SCORE of the loan, the weights being assigned on the basis of the relative strategic importance of each of these three parameters specific to the bank. Higher the composite score better is the chance of the loan being accepted The calculation of the composite score has certain underlying requirements: Every bank should have a minimum composite score based on its risk appetite. E g., if we fix a minimum composite score of 2, then any loan with a score below 2 should be rejected, no questions asked.

A bank might have a minimum composite score of two, but care should be taken to see to it that most of the loans in the portfolio do not fall very close to the minimum composite score as this would worsen its risk profile. Weights should be assigned to the different performance scores based on the banks future strategies and the current balance sheet status. E.g., a bank with heavy focus on the control of already high NPAs should give higher weights to credit performance score.SCOPE OF ALM The scope of ALM function can be described as follows:

I. Liquidity risk management

II. Management of market risks(including Interest Rate Risk)

III Funding and capital planning

IV. Profit planning and growth projection

V. Trading risk management The guidelines given in this note mainly address Liquidity and Interest Rate risks. The guidelines specify the use of a maturity ladder up to 8 time buckets and calculation of cumulative surplus or deficit of funds at selected maturity dates is adopted as a standard tool. The formats of statement of structural liquidity are given by the Reserve Bank of India. Detailed guidance also is given for the classification of the assets & liabilities in each time bucket. For instance, the trading book securities are to be shown less than one day to 30 days, over 1 month & up to 2 months, etc., time buckets on the basis of defeasance periods. Guidelines also provide a format for estimating short-term dynamic liquidity in a time horizon spanning one day to six months. This tool is to be used for estimating short-term liquidity profiles on the basis of business projections and other commitments. The gap i.e., the difference between rate sensitive assets and rate sensitive liabilities is to be used as a measure of interest rate sensitivity. The guidelines also provide benchmarks about the classification of various components of assets and liabilities into different time buckets for preparation of GAP reports. However, banks need to estimate the future behaviour of assets and liabilities and off--balance sheet items in response to changes in market variables and also the probabilities of options on internal transfer pricing model for assigning values for funds sourced and funds used for operating their ALM system. In fact, such estimates provide a rational framework for pricing of assets and liabilities. I. Liquidity Risk Management:

Measuring and managing liquidity needs are vital activities of commercial banks. By assuring a bank's ability to meet its liabilities as they become due, liquidity management can reduce the probability of an adverse situation developing. The importance of liquidity transcends individual institutions, as liquidity shortfall in one institution can have repercussions on the entire system. Bank management should measure not only the liquidity positions of banks on an ongoing basis but also examine how liquidity requirements are likely to evolve under crisis scenarios. Experience shows that assets commonly considered as liquid like Government securities and other money market instruments could also become illiquid when the market and players are unidirectional. Therefore liquidity has to be tracked through maturity or cash flow mismatches. For measuring and managing net funding requirements, the use of a maturity ladder and calculation of cumulative surplus or deficit of funds at selected maturity dates is adopted as a standard tool. he Maturity Profile as given could be used for measuring the future cash flows of banks in different time buckets. The time buckets given the Statutory Reserve cycle of 14 days may be distributed as under:

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 12 months

Over 1 year and up to 2 years

Over 2 years and up to 5 years

Over 5 years

Within each time bucket there could be mismatches depending on cash inflows and outflows. While the mismatches up to one year would be relevant since these provide early warning signals of impending liquidity problems, the main focus should be on the short-term mismatches viz., 1-14 days and 15-28 days. Banks, however, are expected to monitor their cumulative mismatches (running total) across all time buckets by establishing internal prudential limits with the approval of the Board / Management Committee. The mismatch during 1-14 days and 15-28 days should not in any case exceed 20% of the cash outflows in each time bucket. If a bank in view of its asset -liability profile needs higher tolerance level, it could operate with higher limit sanctioned by its Board / Management Committee giving reasons on the need for such higher limit. A copy of the note approved by Board / Management Committee may be forwarded to the Department of Banking Supervision, RBI. The discretion to allow a higher tolerance level is intended for a temporary period, till the system stabilizes and the bank is able to restructure its asset -liability pattern. he Statement of Structural Liquidity may be prepared by placing all cash inflows and outflows in the maturity ladder according to the expected timing of cash flows. A maturing liability will be a cash outflow while a maturing asset will be a cash inflow. It would be necessary to take into account the rupee inflows and outflows on account of forex operations including the readily available forex resources ( FCNR (B) funds, etc) which can be deployed for augmenting rupee resources. While determining the likely cash inflows / outflows, banks have to make a number of assumptions according to their asset - liability profiles. For instance, Indian banks with large branch network can (on the stability of their deposit base as most deposits are renewed) afford to have larger tolerance levels in mismatches if their term deposit base is quite high. While determining the tolerance levels the banks may take into account all relevant factors based on their asset-liability base, nature of business, future strategy etc. The RBI is interested in ensuring that the tolerance levels are determined keeping all necessary factors in view and further refined with experience gained in Liquidity Management. In order to enable the banks to monitor their short-term liquidity on a dynamic basis over a time horizon spanning from 1-90 days, banks may estimate their short-term liquidity profiles

On the basis of business projections and other commitments. An indicative format for estimating Short-term Dynamic Liquidity is enclosed. Scenario Analysis:

Liquidity analysis scenarios are generated. A typical measure would involve worst case (MCO analysis), best case and likely. (This may be used to commit money in money markets). These scenarios are scrutinized and their impact approved by ALCO as a matter of routine. All analysis referred to above provide measures enabled by these scenarios. Many banks, as a matter of routine, create scenarios on top of native cash flows. They alter nature of native cash flows based on their prior knowledge. Derived cash flows are indeed scenarios that have been pre-defined. Recent volatility in the wholesale funding markets has served to highlight the importance of sound liquidity risk management practices and reinforce the lesson that those banks with well- developed risk management functions are better positioned to respond to new funding challenges. The banking industry has developed many innovative solutions in response to these challenges, some of which are presented here. Because banks vary widely in their funding needs, the composition of their funding, the competitive environment in which they operate, and their appetite for risk, there is no one set of universally applicable methods for managing liquidity risk. Strategic Direction

Bank management, generally through ALCO, must articulate the overall strategic direction of the banks funding strategy by determining what mix of assets and liabilities will be utilized to maintain liquidity. This strategy should address the inherent liquidity risks, which are generated by the institutions core businesses. For instance, if the bank has major positions in global capital markets, then liquidity should be managed to lessen the impact of sudden changes in global markets. Or if the bank funds commercial loans with core deposits, then liquidity should be managed to reduce the impact of a decline in asset quality or a runoff of core deposits. This strategy must be documented through a comprehensive set of policies and procedures and communicated throughout the bank.

Integration

Liquidity management must be an integral part of asset/liability management. The banks asset and liability management policy should clearly define the role of liquid assets along with setting clear targets and limits. In the past, asset/liability managements goal was primarily to maximize revenue while liquidity management was managed separately. This resulted in situations where asset and liability profiles structured for maximum profitability had to be reconfigured (often at a loss) to meet sudden liquidity demands. While the struggle between maximizing profitability and providing adequate liquidity continues to this day, the best ALCO groups have realized that liquidity management must be integral to avoid the steep costs associated with having to rapidly reconfigure the asset/liability profile from maximum profitability to increased liquidity. Some of the greatest changes in risk management have occurred in the integration area. Instead of liquidity management being the responsibility of a small group of staff, it is now integrated into the day-to-day decision-making process of core business line managers. This is frequently done through the use of loan growth and balance sheet targets that are pushed down to business line managers. Some banks achieve this goal through the use of a transfer pricing system - giving liquidity-generating business lines an internal earnings credit while charging liquidity-using business lines cost centers for funding. Another innovative method is to require business lines to structure deals as if they had to fund them on a stand-alone basis. Measurement Systems

Most banking experts agree that maintaining an appropriate system of metrics is the linchpin upon which the liquidity risk management framework rests. If they are to successfully manage their liquidity position, management needs a set of metrics with position limits and benchmarks to quickly ascertain the banks true liquidity position, ascertain trends as they develop, and provide the basis for projecting possible funding scenarios rapidly and accurately. In addition, the bank should establish appropriate benchmarks and limits for each liquidity measure. The varied funding needs of institutions preclude the use of one universal set of metrics. As a result, banks frequently use a combination of stock and flow liquidity measures or have gone to exclusive reliance on models. Stock measures look at the dollar levels of either assets or liabilities on the balance sheet to determine whether or not these levels are adequate to meet projected needs. Flow measures use cash inflows and outflows to determine a net cash position and any resultant surplus or deficit levels of funding. Models are built utilizing hypothetical scenarios to develop measures, benchmarks, and limits. Balance-sheet-based measures are generally best suited to smaller institutions which fund their business lines, generally loans, with core deposits. These banks generally develop their measurement system and their corresponding benchmarks and limits based on either selected peer group analysis or on studies of historical liquidity needs over time. In addition, most of these banks utilize flow measures to determine their net cash position. While this combination works well for smaller banks, regional and global institutions that have significant trading operations and are heavily reliant on purchased funding find that stock and flow measures are no longer adequate to meet their needs. As a result, these banks have either developed or have purchased model-based measurement systems to assist them in liquidity measurement.

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. II. Management of market risks(including Interest Rate Risk)

Interest rate risk is measured using traditional techniques for measurement of market risk. Market risk exists due to volatility of interest rates. Financial institutions make money as they take market risk. For example, if a bank provides a 10 year housing loan, then it is has to locate 10 year assets to minimize market risk for that loan. Both traded and non-traded assets and liabilities carry market risk and any technique should address this. All products carry market risk and this need to be addressed as well. It must be understood that all statistical techniques are forecasting algorithms based on history in some form or the other. There is no guarantee that history will repeat itself and new paths and patterns may emerge. Statistical techniques help make judgments. They are not replacements for flesh and blood managers. Gap between interest rate sensitive assets and liabilities, spread over time is a measurement of market risk. This measure is a basic measurement technique. Sensitivity of Net Interest Income (NII) to interest rate change is another way of measuring the interest rate risk. The Basel Committee on Bank Supervision stipulates the benchmark in this regard as the 200 basis points parallel shift in yield curve. However, central banks of individual countries have the freedom to vary this norm. traditionally, banks have a trading book and a banking book. The Basel Committee also uses this differentiation. The essential distinction between a banking book and a trading book is in the method used for the recognition of the risks and valuation. For purposes of determining interest rate sensitivity, both books may be mapped to zero coupon bonds, preserving market risk. Combined book represents a reasonable estimate of banks interest rate risk profile. The application of techniques like modified or dollar duration gap and convexity gap analysis to such a profile will enable risk measurement of interest rate sensitivity. Interest rate Gap

Interest rate gap of a bucket is calculated in a manner similar to liquidity gap. Tolerance of gap in terms of percentage, absolute values is a risk control measure. Tolerance provides control point as well. Buckets may be determined carefully. Making buckets too small leaves a large number of buckets. Making them too large may hide some sensitivity issues Gaps may be identified in the following time buckets:

I) up to 1 month

ii) Over one month and up to 3 months

iii) Over 3 months and up to 6 months

iv) Over 6 months and up to 12 months

v) Over 1 year and up to 3 years

vi) Over 3 years and up to 5 years

vii) Over 5 years

viii) Non-sensitive 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: 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: 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. Credit Derivatives:

The role of a bank in any economic system is financial intermediation. This essentially involves borrowing and lending of funds and assuming the risk of lending in the process. Current banking practices view the management of credit risk outside the scope of the ALM framework. Credit risk, as most bankers claim, is taken care of by having stringent lending preconditions and diligent monitoring of the loan portfolio. The regulators are happy with stringent reporting norms with reference to provisions for non-performing assets. However, in a banking system where 40% of the loan able funds are locked in the priority sector and competitive pressures often driving the banks to compromise on the self-devised stringent lending norms, the fact that banks carry substantial credit risk on their balance sheets cannot be ignored. When one talks of lending, the first issue that should come up is the borrowers credibility. Credit risk management is not a new concept. Exposure to credit risk has long been hedged or reduced through portfolio diversification, collateral and by making provisions against possible defaults. In todays global market, these tools seem inefficient and the time- honored view of the credit market needs re-examining. Credit risk differs from market risk in that the default risk of an individual company is tied to its own performance and not to the performance of other companies. In fact, there is a low correlation between the default risk of an individual counterparty and any aggregate index of corporate performance such as the market index. So, default risk cannot be hedged by means of a market index, future contracts or by matching within the existing book. The only way actually today off default risk is by means of some instrument that is directly related to the specific compINADEQUACY OF BALANCE SHEET ANALYSIS FOR ALM

ALM techniques are used over and above balance sheet techniques. First of all, ALM takes into account the time value of money whereas balance sheet accounting ignores time element. Secondly, ALM requires factoring the off-balance sheet items to estimate their potential impact on the banks e.g., unutilized portion of cash credit. Further, the ALM involves holistic perspective for decision-making and factors in the market dynamics.

Mapping Non-term products

Certain products like savings bank have no contracted maturity terms. Therefore, there is conceptual difficulty in mapping them into zero coupon bonds as the timing of the occurrence of such cash flows is not known. They are generally split into two or more parts based on their behavior. These parts are volatile and core. Core is expected to be with the bank and will mature in later time buckets. Volatile portion is typically assigned to the first bucket.

Probabilistic cash flow products

Savings bank and current account are examples form the banking book of probabilistic cash flow behavior. Probability is deliberate in derivative class of instruments. Thus, complex and sophisticated models are required to map derivative type of instruments into the cash flow model.

Options, Futures and derivatives

Bank uses these instruments to hedge positions. To offer a customer a long position in US Dollar at a certain rate, bank has to hedge by taking a corresponding short position. Thus, regardless of US Dollar rate changes, bank is fully protected, offering customer protection as well. Thus, options, futures and derivatives may be used to take positions, apart from hedging. Basel II norms specify different treatments for the derivatives.

Transfer Pricing for Measuring Profitability

Profitability by business units, as given out by simple balance sheet is distorted. A business unit or a branch located in a residential area is by definition a deposit-taking branch. Thus, its profitability should be measured by efficiency of deposit collection i.e., weighted average interest rates of deposit collection by time buckets compared to a standard yield curve. Thus, concept of funds transfer pricing has emerged strongly in the past few years. STRATEGIZING ALM FRAMEWORK

ALM policy is drafted and updated by banks ALCO. ALM policy requires that board of directors, Asset Liability committee follow a formal procedure. ALM Policy covers banks position on all risks credit risk, market risk, liquidity risk etc. Banking keeps changing and in times will change even further. Thus, ALM policies need to change with the changes in the market on a continuous basis. This ensures that practices are current, though business itself does not change. In India, for example, for a large number of years, it was liability creation that was the prime driver. Once bank gathered enough funds, the banks would look at multiple asset creation avenues. However, of late, it is the asset creation that drives the liability growth. Product: Both assets and liabilities are considered products and operational parameters defined for both. For example, deposits may have various characteristics and structures for interest rates. Even plain vanilla deposits need to be priced and priced by timeframe. Competition may introduce new products based on their ALM positions. The policy defines products that the bank may deal in both on assets and liabilities.

Complexities are introduced by options both explicit and embedded. Savings bank and cash credit is a classic case of embedded options. Thus, ALCO needs to understand impact of probabilistic cash flows before approving such products. Before being offered, product creation needs to go through a proper introduction and approval mechanisms through Risk Management and ALCO. Thus, policy should address parameters that should never be crossed. Structural Liquidity: Structural liquidity is critical for an institution. Therefore, policies must be laid out for measurement and implementation of liquidity controls in any financial institution. Individuals practice structural liquidity measurement and control for personal portfolios. Hence, these are even more vital for a financial organization. Gap Measurement:

time buckets are defined as bands. 1-14 days, 15-days to 1 month, 1 month to 2 months etc. is an example. This organization is termed a maturity bucket scheme. All cash flows are mapped to corresponding buckets. Thus, entire portfolio of cash flows is now reduced to a bucket representation, thus making it easier to analyze. Since all products are mapped, assets represent all inflows and liabilities represent all outflows. Thus gaps in each time bucket are analyzed. Regulators specify use of percentage of tolerance for gaps. Practical bankers use an absolute amount. us, as long as gap remains within tolerance, then it is deemed zero. Thus, the statement in the beginning that zero gap is impractical and not desired either. Banks funding or lending gaps may be very deliberate. Procedures for Reducing Exposure to Rising Rates (Closing a Negative Gap):

During a period of climbing interest rates, a credit union which is funding its long term loans with short term deposits (negative gap) will experience rising financing costs as its deposits float at increasingly high rates. In order reduce this exposure, the following procedures may be applied to shorten the term of assets and lengthen the term of liabilities:

Price products so that favorable rates encourage shorter maturities for loans and longer maturities for deposits. Unfavorable rates should be used to discourage loan/deposit terms that will enlarge the negative gap.

Where pricing policy will not stem demand for longer term, fixed rate assets, restrict the availability of fixed rate loans.

Change portfolio mix in favor of variable rate loans. Promote variable rate consumer loans over fixed rate mortgages. Consumer or commercial loans earn a higher yield and can be matched against variable rate deposits.

Market/promote products which will close the gap position. Recommended methods of promoting products include advertisements, in-branch posters and contest prizes. Inform staff of their priority to increase certain product volumes through cross selling efforts.

Where new business is not available to correct the gap position, encourage the conversion of maturities in the existing portfolio. Allow members to negotiate in mid-term an extended maturity for fixed rate deposits, or convert closed fixed rate loans to open loans to encourage prepayment.

Consider selling a portion of the fixed rate mortgage portfolio to other industry players. Such an arrangement allows ongoing member contact, the correction of an unfavorable mismatch and the option to earn a return for continuing service. Procedures for Reducing Exposure to Falling Rates (Closing a Positive Gap): He same procedures as those described above may be used to reduce exposure to falling rates (close a positive gap), except that the opposite tactics should be employed. In an environment of falling interest rates, a credit union which is funding short-term loans with long-term deposits will experience shrinking revenues and financial margin as its loan interest income falls while deposit interest expense remains fixed. In brief, the following approaches are recommended to reduce exposure to falling interest rate (close a positive gap):

Price products to dampen demand for variable rate loans and fixed rate term deposits.

where pricing does not stem demand, restrict funds available for variable rate loans.

Change portfolio mix in favour of fixed rate mortgages.

Market and promote products which close the gap.

Allow members to extend mortgage terms at current fixed rates.

Create incentives for members to cash term deposits early.

Invest excess liquidity of the investment portfolio into longer term vehicles. Cost to close gap: This is another measurement for structural liquidity. The last bucket is closed first using market interest rate for that bucket. Some implementations divide all buckets to months internally and calculate cost to close at month level. Cost to close of the last bucket is them taken as an outflow in the previous bucket and that closed and so on all the way till the first bucket is closed. That gives the total cost to close gap. the other way is to simply calculate cost to close gap for each bucket based on interest rate and assuming that all cash flows occur at the gap median. tolerance to limits of cost to close is defined as a measure of structural liquidity risk and this is used for control.

IMPLEMENTATION ISSUES Policy: Lack of a coherent, documented and practical policy is a big hindrance to ALM implementation. Most often, ALCO membership itself may not be aware of implications of risks being measured and impact. Policies should address all issues concerning the bank, all policies should be clearly explained to all members of board, apart from ALCO and these must be documented. Proper revisions to this document, a quarterly review needs to be organized as well as parameters may be changing due to change in situations. Understanding of complexities:

Many people in a bank need to understand risk measurements and risk mitigation procedures. Measurement of risk is a fairly simple phenomenon and does go on regardless. Formalization of understanding, especially at a top level, will be helpful as it would help in decision making. Organization and culture:

ALM function needs to be separated clearly from operations as it involves control and strategy functions. Risk organization in banks generally land up reporting to treasury, as they are people who come closest to understanding complex financial instruments. The fact that they are a business unit, in charge of risk taking is overlooked. Risk Taking and Risk management are generally two distinct parts of any organization and both must report to a board completely independently. Openness and transparency are essential to a proper risk organization. Most organizations react badly to some positions going wrong by taking more risks and enter vicious cycle of risks. Thus, it is required to follow policy implicitly in both letter and spirit. Most dramatic failures in the last decade have not been because of market risk or credit risk but bad risk management organizations. This must be a big pointer to boards and ALCOs on avoidance of such issues Data and models:

Data may not be available at all times in requisite format. It must be remembered that many data items are assumptions and gaps must be measured in perspective. There was a case of a manual branch of a bank that was closed for 6 months in a year due to inclement weather and was largely inaccessible. As data may not be obtained from this branch for 6 months, appropriate assumptions have to be made in any event. The argument is that for all other purposes, assumptions are being made. Sensible options need to be chosen and manual branch without computer was an example. However, in modern banking, it is mapping of models to zero coupon bonds that are an issue. Once again, arguments are that this should exist within the bank. Unrealistic goals:

An ALCO secretary was seen desperately trying to tweak with parameters to show less gaps in liquidity reports. A zero gap is not practical. Returns are expected for taking risks. Banks assume market and credit risk and hence they make returns. ALCOs job is to correctly determine positions and put in place appropriate remedial measures using appropriate risks. It is not to show things as good when they are not. In any event, market risks and credit risks are not the only causes for failure, as evidenced by failures in the last decade.INFORMATION TECHNOLOGY AND ASSET-LIABILITY MANAGEMENT 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. 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. his 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.

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 behaviour 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 informationASSET - LIABILITY MANAGEMENT SYSTEM IN BANKS GUIDELINES

Over the last few years the Indian financial markets have witnessed wide ranging changes at fast pace. Intense competition for business involving both the assets and liabilities, together with increasing volatility in the domestic interest rates as well as foreign exchange rates, has brought pressure on the management of banks to maintain a good balance among spreads, profitability and long-term viability. These pressures call for structured and comprehensive measures and not just ad hoc action. The Management of banks has to base their business decisions on a dynamic and integrated risk management system and process, driven by corporate strategy. Banks are exposed to several major risks in the course of their business -credit risk, interest rate risk, foreign exchange risk, equity / commodity price risk, liquidity risk and operational risks. this note lays down broad guidelines in respect of interest rate and liquidity risks management systems in banks which form part of the Asset-Liability Management (ALM) function. The initial focus of the ALM function would be to enforce the risk management discipline viz. managing business after assessing the risks involved. The objective of good risk management programmes should be that these programmes will evolve into a strategic tool for bank management. ASSET-LIABILITY MANAGEMENT DECISIONS IN PRIVATE BANKING

Working from the observation that the contribution of asset-liability management techniques developed for institutional investors is not yet familiar within private banking, a new study from the EDHEC Risk and Asset Management Research Centre, entitled Asset-Liability Management Decisions in Private Banking shows the expected benefits of a transposition of that kind. According to the authors of the study, Nol Amenc, Lionel Martellini and Volker Ziemann, asset-liability management represents a genuine means of adding value to private banking that has not been sufficiently explored to date. Within the framework of private financial management offerings, personal wealth managers tend to confine their clients to mandates that are only differentiated through their level of volatility, without the clients personal wealth constraints and objectives being genuinely taken into account in order to determine the overall strategic asset allocation. In that sense, private wealth management is not sufficiently different from the management of a diversified or profiled mutual fund. It is not so much the risk-adjusted performance of a fund or even of a given asset class that is the determining factor in including it in the clients personal wealth, but its capacity to match the clients liabilities. The clients liability constraints (horizon, nature, amount and certainty of future cash flows that will be received and invested; their projects, which could have varying exposures to risk factors, whether it involves real estate or inflation) must be taken into account in managing their assets; which private bankers rarely do when they put together their clients overall strategic asset allocation. In the end, it is not so much the short-term risk represented by the volatility of the assets that is the determining element in taking an individuals risk aversion into account, but the probability or the expectation of the individuals long-term financial objectives not being achieved. Taking these elements into account leads to asset allocations that are very different from the allocation provided by an optimization carried out in a static mean-variance or mean-VaR framework, as performed by the vast majority of private wealth managers. ASSET LIABILITY MANAGEMENT SYSTEM

ALM is a risk management tool that helps a bank's management take investment / disinvestment decisions, maintain the required statutory liquidity ratio (SLR), credit reserve ratio (CRR) and other ratios as per Reserve Bank of India (RBI) guidelines. It generates the SLP / IRS / MAP / SIR reports and supports risk management modules like graphical analysis, data analysis and interest rate simulation. Basically, the Asset Liability Management System consists of seven modules: Administration: the administration module lets the administrator conduct various user activities as well as some distinct functions. The administrator can add a new user, modify or delete an existing user or lock / unlock a user. Various categories linked with a group of users can be set. This module sets up user-level permissions to access different options from the ALM system, depending on the category of the user.

Registration: this module handles registration of the bank and its branches into the ALM system. Before extracting data from any branch, it is necessary to register the branch. The bank / branch ID and address are also updated