ALM Process:

The scope of ALM function can be described as follows:

1. Liquidity risk management

2. Management of market risks

3. Trading risk management

4. Funding and capital planning

5. Profit planning and growth projection

6. The guidelines given in this note mainly address Liquidity and Interest Rate risks.

Measuring and managing liquidity needs are vital for effective operation 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. Banks 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 different assumptions. 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. The format of the Statement of Structural Liquidity is given in Annexure I.

The Maturity Profile as given in Appendix I 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. 1 to 14 days

2. 15 to 28 days

3. 29 days and upto 3 months

4. Over 3 months and upto 6 months

5. Over 6 months and upto 1 year

6. Over 1 year and upto 3 years

7. Over 3 years and upto 5 years

8. Over 5 years

The investments in SLR securities and other investments are assumed as illiquid due to lack of depth in the secondary market and are therefore required to be shown under respective maturity buckets, corresponding to the residual maturity. However, some of the banks may be maintaining securities in the 'Trading Book', which are kept distinct from other investments made for complying with the Statutory Reserve requirements and for retaining relationship with customers. Securities held in the 'Trading Book' are subject to certain preconditions like :

• The composition and volume are clearly defined;

• Maximum maturity/duration of the portfolio is restricted;

• The holding period not to exceed 90 days;

• Cut-loss limit prescribed;

• Defeasance periods (product-wise) i.e. time taken to liquidate the position on the basis of liquidity in the secondary market are prescribed;

• Marking to market on a daily/weekly basis and the revaluation gain/loss charged to the profit and loss account; etc.

Banks which maintain such 'Trading Books' and complying with the above standards are permitted to show the trading securities under 1-14 days, 15-28 days and 29-90 days buckets on the basis of the defeasance periods. The Board/ALCO of the banks should approve the volume, composition, holding/defeasance period, cut loss, etc. of the 'Trading Book' and copy of the policy note thereon should be forwarded to the Department of Banking Supervision, RBI.

Within each time bucket there could be mismatches depending on cash inflows and outflows. While the mismatches upto 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 mismatches (negative gap) during 1-14 days and 15-28 days in normal course may not exceed 20% of the cash outflows in each time bucket. If a bank in view of its current asset -liability profile and the consequential structural mismatches needs higher tolerance level, it could operate with higher limit sanctioned by its Board / Management Committee giving specific reasons on the need for such higher limit. The discretion to allow a higher tolerance level is intended for a temporary period, i.e. till March 31, 2000.

The Statement of Structural Liquidity ( Annexure I ) 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 also be necessary to take into account the rupee inflows and outflows on account of forex operations. 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 rolled-over) afford to have larger tolerance levels in mismatches in the long-term 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 for planning purposes. An indicative format ( Annexure III ) for estimating Short-term Dynamic Liquidity is enclosed.