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Issues in Asset Liability Management - IAuthor(s): A. V. RajwadeSource: Economic and Political Weekly, Vol. 37, No. 5, Money, Banking and Finance (Feb. 2-8,2002), pp. 378-379Published by: Economic and Political WeeklyStable URL: http://www.jstor.org/stable/4411679 .

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I s s u e s i n A s s e t LiabilityManagementThesubjectof asset liabilitymanagement s of relativelyrecentoriginbothinternationallyand, moreso, in India. This is thefirst of a series of articles which will discuss the different ssuesinvolved,criticallyexaminethe maturitygap model,suggestalternatives, ook at theprinciples of pricing depositsandadvances and deal withconnectedsubjects.A V RAJWADEIn termsof bank upervisoryoncerns,asset liability management is a relatively recent subject. Historically, su-pervisoryconcerns were more focused oncredit risk than on interest rate risk. Thelatter became a matter of crucial impor-tance only after the deregulation of bankinterest rates in the US in the late 1970s;we in India followed suit in the 1990s.IntheUS, thebiggest impactof deregu-lated interest rates was felt by the savingsand loan, ie, housing finance, industry.The industryhad to be bailed out at a hugecost to the taxpayerrunning nto hundredsof billions of dollars. To be sure,the losseswere much more than whatthey otherwisewould have been because, in 1979, theUSFederalReservechangedtheway itimple-mentedmonetarypolicy. Traditionally andeven now) it has targeted the overnightinterbank ate,theso-called FederalFundsRate, through open marketoperations. In1979, in a bid to curb inflation, the Fedstarted argetingmoney supplyrather haninterest rates, resulting into very high -and volatile - interest rates, an explosivemixture whose victims included the sav-ings and loan industry. (The other majorsegment hit by the sky-high USD interestrateswere the third world countries whichhadraisedhuge LIBOR based loans in the1970s to pay for the galloping oil bill: the1980s debt crisis was the result.)

Butturningback to the savings and loanindustry, ordecades,the nterest heycouldcharge on housing loans, their principalactivity, and pay on deposits, were regu-lated (wags used to refer to savings andloans bankers as 3-6-3 bankers:pay inter-est at 3 per cent on deposits, charge in-terestat6 percent on loans, andgo to playgolf at 3 PM!). When interest rates werederegulated in the US, the cost of fundswent up sharply.To avoid making losses,savings and oans increased theirexposuretoriskyassetslikejunkbonds,ina dramatic

fashion.When majordefaults occurredpartly lso because f therecession esult-ing from the high interestrates,a largesegmentof thesavingsand oanindustrywent nsolventandultimately ost theUStaxpayer omethingike$ 500bn.Indeed,the savingsandloanindustryn US is acasestudynwhat anhappenwhen nterestratesarederegulatednd he ndustry oesnot takestepsto managerisksproperly.The subjectof asset liabilitymanage-ment covers both interestrate risk andliquidityrisk.However, t is proposed ofocus on the former.This is of crucialimportanceo allthosefinancial nterme-diaries ike banks,financial nstitutions,NBFCsandprimary ealers,whoseprin-cipalsourceof earningss the net interestmargin.Butothersoocanbehit. na recentUK case, a centuries-oldife insurerhashad to close downoperationsbecause tassured eturnsopolicy-holdersasedonthehighinterest atesof the 1970s- andis unableto meet the obligations n theruling,much ower interest atescenario.As faras banksareconcerned,heBasleCommitteeon BankingSupervisionhasbeenconcernedwith hequestion f inter-est raterisk forseveralyearsnow. It hasalreadybroughtwithin hepurviewof itscapitaladequacy orms hetopicof inter-est rate risk in the tradingactivitiesofbanks.While no capitaladequacynormshave so far been made applicable tothenon-trading ctivitiesof the bankingsystem(suchas normaldepositsandad-vances),the Basle Committeehas comeout with a reportitled'PrinciplesortheManagementof InterestRate Risk' inSeptember997.The ullreports availableon the web site of the Bank for Inter-nationalSettlements www.bis.org).Indian Scenario

In recentyears in India,most of theinterest rates have been deregulated;governmentecurities re old nauctions

and banks arealso, with a few exceptions,free to determine the interest rates ondeposits and advances.Historically, banksin India have not paid much attention tothe topic of management of the interestratemainly because all interest rateswereregulated by the central bank. With thechanging scenario, the topic assumes agreat deal of importance as market deter-mined interest rates inevitably lead tovolatilityandhence interestraterisk.Again,with a large partof the securities portfolionow subject to 'mark to market' valuationfor compiling accounts, banks' bottomlines are vulnerable to changing interestrateson this scoreaswell,i e, over and abovethe fluctuation in the net interest margin.It is manifest thatthe greaterthe capitalintensiveness of a business, greateris theimpact of interest rate changes on thebottom line. Amongst all businesses,banking is perhapsthe most capital inten-sive since the gross value added throughintermediation(orthe net interestincome)as a proportion of the capital employedis perhapsthe lowest- clearly an evidenceof the extremely capital-intensive natureof banking. While rigorous data abouttheimpact on the rupee book of Indianbanksof interest rate changes are not available,the author knows of many banks havinglost substantialamounts on theirFCNR(B)portfolios through a lack of appreciation,identification and management of theinterest rate risk. The impact on the farmore complex rupee book is hardlylikelyto be significantly different.

Thisapart, he Indianmutual unds ndus-try has also been a major victim of mis-managing assets and liabilities, with thecost running o well inexcess of Rs 10,000crore. Take the case of US 64 which, forall practicalpurposes, was perceived as anassured income scheme, andwhich is nowin deep trouble. To my mind, the problemarose primarily because of significantinvestment in equities, on which obvi-ously there are no assured returns!Quiteapart rom US 64, many banks, as trusteesof assured returns on various schemes,have suffered losses totalling a few thou-sand crore in meeting their obligations.Unlike US 64, most such schemes wereclose-ended. But the problem was thattheasset investment policy was not such asto earntheassured returnon the liabilities.For close-ended schemes, assured returnswould be possible only if the entiremoneyis invested in fixed income securities, andthe duration of the portfolio is so kept asto coincide with thematurityof the scheme.But focusing on banks and financialinstitutions, their dependence on net in-terest margin for meeting their costs and

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earningprofits s high as the followingdata evidence.(As PerCentof TotalAssets)

Commercial Financial NBFCsBanks Institutions 1999-(2000-2001) 2000-2001) 2000)Net Interestncome 2.84 1.60 6.5Otherncome 1.32 0.95 1.2Operatingxpenses 2.64 1.06 4.0Surplus 1.52 1.49 3.7Source: Report n Trend ndProgressofBankinginIndia 000-01, RBI.Clearly,protecting/improvinghe net in-terestmargin n a changing nterestratescenariohroughppropriatesset iabilitymanagements importantor them.Asset Liability Structuresof Different Entities

As far as thefinancial ntermediariesnIndiaareconcerned,heprincipal nes arethecommercialanks,he inancialnstitu-tions,and heprimary ealers.The nterestrate risk arises from the mismatch inmaturitiesf the assetsandthe liabilities.As far as the commercialbanks areconcerned,particularlyhe largerIndianpublicsectorbanks, he principal ourceof mismatch s their holdingsof fixedincome ecurities spartof their tatutoryliquidityportfolio.Thebulkof the liabili-ties of thecommercial anksarerelativelyshortterm,while the portfolioof fixedincomesecurities,which formsa signifi-cantproportionf their otalassets,oftenhas a much ongerduration f maturity.Thismismatchan ead osubstantialosseson the fixed incomeportfoliowhen nter-est ratesgo up. The Reserve Bankhasprescribedcapital dequacy orm ortheholding in governmentsecurities as acushionagainst heinterest aterisk.Butthis is verynominal.Again, t is not as ifthatportfolio lone s thesourceoftherisk.On the liabilityside, the fixed depositportfoliosalsoa source frisk,quiteapartfrom theriskof depositors hifting romsavingsbank accounts o fixed depositswhen nterestatesarehigh, urther ddingto costs.Banksalso face a risk from theoptionsembedded n the fixed depositportfolio hroughhe freedom o the de-positorsorprematurencashment.Whilecontractually obodycanforcea bank omake prematurepaymentof the fixeddeposit, n practice ew banks can resistsuch requests.Asfor hefinancialnstitutions,hebulkof their liabilitiesare bullet repaymentbonds,while mostof the assetsare n theformof instalmentepaymentoans. In away, therefore, he financial nstitutionshaveanexactlyoppositemismatcho that

of the banking ystem,with the averagematurity f the liabilitiesportfolioongerthanthat of the asset portfolio.Primarydealersalso face a significantamount f riskastheyoftenborrowntheinterbank all moneymarket or invest-ment in datedgovernmentecurities.Toan extent,primary ealersarein a betterposition to take the risk, because theirgearingsmuch ower han hatof theotherfinancial ntermediaries.RBI Guidelines

The Reserve Bank of India came outwith its guidelines on Asset LiabilityManagementystem nBanks nFebruary1999.Theseguidelines overnotonlythetopicof interest ateriskbutalsoliquidityrisk and a few otherpricerisks.RBIhasissuedseparateALMguidelinesorfinan-cial institutions(December 1999) andNBFCs(June2001). All threeguidelinesare similarand the differences are notmeaningful.TheReserveBank'sguidelinesorbanksissued nFebruary 999were o beimple-mentedwitheffect romApril1,1999.Theguidelines ecognise hat omebanksmayhavealready n placemoresophisticatedsystems,whileothersmaynothaveproperdatato cover 100 percent assetsand li-abilities.The objectivetherefore s that,to startwith, at least 60 per cent of theassets and liabilities should be covered,but 100percentcoverage s mandatoryndue course. While the guidelines takematurity aps in different imebands ortimebuckets s thestarting oint, heyalsoenvisage that in course of time moresophisticatedmeasurementystems likeduration ap,simulation ndvalueatriskanalysiswould be introduced.The guidelinesspecify the followingthreefoundations f asset liabilityman-agement(1) ALMInformationSystem

The promptavailabilityof assets andliabilities data, including in particularresidualmaturities,as also off-balancetransactionsike interestrateswaps,arethekeyto aneffectiveALMstrategy.Thiswouldpresenta major hallenge o banksin India which may not be optimallycomputerised. gain, hedata romalltheofficesshouldbeelectronicallyollatedata centralplace.Since it will taketime formany banks to put in place a suitablesystem, heguidelinesadvocated n ABCapproach, e, using datafrom a limitednumberof branches butwhichaccountfor a significantproportionf thebank's

total assets and liabilities), to prepareestimates or the bank as a whole.(2) ALMOrganisation

Atthe opof theALMorganisations theboardof directorswhichhasfinalrespon-sibilityor he unction.tshoulddecide heriskmanagementolicy,andspecify imitsfor interest ate(andother)risks.The nexttier of the ALMorganisationis the AssetLiabilityCommitteeALCO)which would be responsibleorensuringthat hepoliciesand imitssetbytheboardare mplemented.ALCOwouldconsistofsenior executivesof the bank,and alsodecide thebusinessstrategyon the assetsand iability ide, nparticularnterest atepricing, esiredmaturity rofile,mixof in-cremental ssetsand iabilities, tc.ALCOshouldalso articulatehe bank'sviews onthe nterest atemovements nddevisethefundingmix.ALCOwouldbeassistedbya support roup romthe bank's reasury.The managementor anotherspecial)committee f theboard houldoversee heimplementationf the ALM systemandreview its functioningwith a view torefining t.(3) ALMProcess

Asfaras the nterest aterisk sconcern-ed,itcanaffectboth henet nterestncomeforagivenperiod, s alsotheeconomic or'market') alueof a bank's quity.Tostartwith, nterest aterisk s to be consideredfromthe angleof the net interestncomeby using maturitygaps in the followingtimebands orbuckets),of the assetsandliabilitiesdue to berepricedneach band:(i) 1 to 28 days;(ii) 29 daysto 3 months;(iii) over3 months o 6 months; iv) over6 months o 1 year;(v) over 1 yearto 3years; vi)over3years o 5years; vii)over5 years;and(viii) not sensitive.If, foranytimebucket, hematurity apis positive, e, ratesensitive assetslargerthan ate ensitive iabilities,hemismatchwould help increase the net interest n-come in a rising nterest atescenarioandvice versa.Eachbank s requiredo placelimits on the extent of gap in each timebucket.The guidelinesalso suggestthata properransfer ricemechanismwithinthe bank s animportant omponent f aneffective and efficient ALM system.The guidelinesalso prescribe he rulesfor classification of various liabilitiesandassets nthedifferentimebuckets. nthenextarticle, wouldconsider he ssuesarising rom herecommendedlassifica-tion of assets and iabilities ntodifferentmaturity uckets.B31

Economic and Political Weekly February 2, 2002 379