Module: 2 -Asset Liability Management

ALM comprises both timely detection of mismatches between assets & liabilities maturing over a time and effecting appropriate steps to remedy the situation.

While most of the banks in other economies began with strategic planning for asset liability management as early as 1970, the Indian banks remained unconcerned about the same. Till eighties, the Indian banks continued to operate in a protected environment. In fact, the deregulation that began in international markets during the 1970s almost coincided with the nationalization of banks in India during 1969. Nationalization brought a structural change in the Indian banking sector. Wholesale banking paved the way for retail banking and there has been an all-round growth in branch network, deposit mobilization and credit disbursement. The Indian banks did meet the objectives of nationalization, as there was overall growth in savings, deposits and advances. But all this was at the cost of profitability of the banks. Quality was subjugated by quantity, as loan sanctioning became a mechanical process rather than a serious credit assessment decision. Political interference has been an additional malady. Externally directed and over-controlled banking operations (like directed credit, directed pricing of all products both assets & liabilities, directed investment etc.) in a captive market insulated them from risk-exposure, since inter-bank competition was non-existent and free market forces were not operating. But the reforms of 1991-92 set a new phase in

As all transactions of the banks revolve around raising and deploying the funds, Asset-Liability Management gains more significance for them. Asset-liability management is concerned with the strategic management of balance sheet involving the management of risks caused by changes in the interest rates, exchange rates and the liquidity position of the bank. While managing these three risks, forms the crux of the ALM, credit risk and contingency risk also form a part of the ALM. Due to the presence of a host of risks and due to their inter-linkage, the risk management approaches for ALM should always be multi-dimensional. To manage the risks collectively, the ALM technique should aim to manage the volume, mix, maturity, rate sensitivity, quality and liquidity of the assets and liabilities as a whole so as to attain a predetermined acceptable risk/reward ratio. The purpose of ALM is thus, to enhance the asset quality, quantify the risks associated.

The various risks that banks are exposed to will affect the short-term profits, the long-term earnings and the long-run sustenance capacity of the bank and hence the ALM model should primarily aim to stabilize the adverse impact of the risks on the same. Depending on the primary objective of the model, the appropriate parameter should be selected. The most common parameters for ALM in banks are:

1. Net Interest Margin (NIM - The impact of volatility on the short-term profits is measured by NIM, which is the ratio of the net interest income to total assets. Hence, if a bank has to stabilize its short-term profits, it will have to minimize the fluctuations in the NIM.

2. Market Value of Equity (MVE) - The market value of equity represents the long-term profits of the bank. The bank will have to minimize adverse movement in this value due to interest rate fluctuations. The target account will thus be MVE. In the case of unlisted banks, the difference between the market value of assets and liabilities will be the target account.

3. Economic Equity Ratio - The ratio of the shareholders funds to the total assets measures the shifts in the ratio of owned funds to total funds. This in fact assesses the sustenance capacity of the bank. Stabilizing this account will generally come as a statutory requirement.

While targeting any one parameter, it is essential to observe the impact on the other parameters also. It is not possible to simultaneously eliminate completely the volatility in both income and market value. If the bank lays exclusive focus on the short-term profits, it may have an adverse impact on the long-term profits of the bank and vice-versa. Thus, ALM is a critical exercise of balancing the risk profile with the long/short term profits as well as its long-run sustenance

Asset Liability Management is strategic balance sheet management of risks caused by changes in the interest rates, exchange rates and the liquidity position of the bank. To manage these risks, banks will have to develop suitable models based on its product profile and operational style. Several techniques are followed by banks in advanced countries for managing ALM.

Techniques for assessing asset-liability risk came to include gap analysis and duration analysis. These facilitated techniques of gap management and duration matching of assets and liabilities. Both approaches worked well if assets and liabilities comprised fixed cash flows. Options, such as those imbedded in mortgages or callable debt, posed problems, which gap analysis, could not address. Duration analysis could address these in theory, but implementing sufficiently sophistic

(Website of Contingency Analysis URL - htttp://www.riskglossary.com//articles/asset_liability_management.htm)

For managing the interest rate risk, common and simple too the Gap Analysis. Based on the sensitivity of the assets and liabilities to the interest rate fluctuations, they are classified into different maturity buckets. The Rate Sensitive Gap (RSG), which is the difference between the rate sensitive assets (RSAs) and the rate sensitive liabilities (RSLs) will enable the banks to assess the impact of the rate fluctuations on their net interest margin (NIM). The model can also be extended to target a RSG so as to attain a positive impact on the NIM. An essential ingredient for this is however, an elaborate MIS at the micro-level. In the case of currency risk management, banks in India have been given the discretion to maintain overnight open positions subject to maintenance of adequate capital.

Duration and convexity are factor sensitivities that describe exposure to parallel shifts in the spot curve. They can be applied to individual fixed income instruments or to entire fixed income portfolios.

The idea behind duration is simple. Suppose a portfolio has duration of 3 years. Then that portfolio's value will decline about 3% for each 1% increase in interest rates—or rise about 3% for each 1% decrease in interest rates. Such a portfolio is less risky than one, which has a 10-year duration. That portfolio is going to decline in value about 10% for each 1% rise in interest rates. Convexity provides additional risk information.

Duration and convexity have traditionally been used as tools for asset-liability management. To avoid exposure to parallel spot curve shifts, an organization (such as an insurance company or defined benefit pension plan) with significant fixed income exposures might structure its assets so that their duration matches the duration of its liabilities - so the two offset. This technique is called duration matching. Even more effective (but less frequently practical) is duration-convexity matching, in which assets are structured so that durations and convexities match.

With scenario analysis, several interest rate scenarios would be specified for the next 5 or 10 years. These might specify declining rates, rising rates, a gradual decrease in rates followed by a sudden rise, etc. Scenarios might specify the behavior of the entire yield curve, so there could be scenarios with flattening yield curves, inverted yield curves, etc. Ten or twenty scenarios might be specified in all. Next, assumptions would be made about the performance of assets and liabilities under each scenario. Assumptions might include prepayment rates on mortgages or surrender rates on insurance products. Assumptions might also be made about the firm's performance—the rates at which new business would be acquired for various products. Based upon these assumptions, the performance of the firm's balance sheet could be projected under each scenario. If projected performance was poor under specific scenarios, the ALM committee might adjust assets or liabilities to address the indicated exposure. A shortcoming of scenario analysis is the fact that it is highly dependent on the choice of scenarios. It also requires that many assumptions be made about how specific assets or liabilities will perform under specific scenarios.

VaR is defined as an estimate of potential loss in a position or asset/liability or portfolio of assets/liabilities over a given holding period at a given level of certainty.

Risk is defined as the probability of the unexpected happening - the probability of suffering a loss. VaR is an estimate of the loss likely to suffer, not the actual loss. The actual loss may be different from the estimate. It measures potential loss, not potential gain. Risk management tools measure potential loss as risk has been defined as the probability of suffering a loss. VaR measures the probability of loss for a given time period over which the position is held. The given time period could be one day or a few days or a few weeks or a year. VaR will change if the holding period of the position changes. The holding period for an instrument/position will depend on liquidity of the instrument/ market. With the help of VaR, we can say with varying degrees of certainty that the potential loss will not exceed a certain amount. This means that VaR will change with different levels of certainty.

The Bank for International Settlements (BIS) has accepted VaR as a measurement of market risks and provision of capital adequacy for market risks, subject to approval by banks' supervisory authorities.

"Stress testing" has been adopted as a generic term describing various techniques used by banks to gauge their potential vulnerability to exceptional, but plausible, events. Stress testing addresses the large moves in key market variables of that kind that lie beyond day-to-day risk monitoring but that could potentially occur. The process of stress testing, therefore, involves first identifying these potential movements, including which market variables to stress, how much to stress them by, and what time frame to run the stress analysis over.

Once these market movements and underlying assumptions are decided upon, shocks are applied to the portfolio. Revaluing the portfolios allows one to see what the effect of a particular market movement has on the value of the portfolio and the overall Profit and Loss.

Stress test reports can be constructed that summarise the effects of different shocks of different magnitudes. Normally, then there is some kind of reporting procedure and follow up with traders and management to determine whether any action needs to be taken in response.

Stress tests supplement value-at-risk (VaR). VaR is thought to be a critical tool for tracking the riskiness of a firm's portfolio on a day-to-day level, and for assessing the risk-adjusted performance of individual business units. However, VaR has been found to be of limited use in measuring firms' exposures to extreme market events. This is because, by definition, such events occur too rarely to be captured by empirically driven statistical models. Furthermore, observed correlation patterns between various financial prices (and thus the correlations that would be estimated using data from ordinary times) tend to change when the price movements themselves are large. Stress tests offer a way of measuring and monitoring the portfolio consequences of extreme price movements of this type.

These systems in general need collection of data from several centres, where the bank’s branches are established and computing complex calculations. Banks who have connected all their branches/officers under a single network (WAN) and use special application software are in a position to secure the advantage of these tools. In India there are very large number of medium and small banks, which are still far away from total computerisation of their operations. Complex tools that6 can be computed only electronically are not suited to many of the Indian Banks. The system devised has to be simple that can be implemented either on the computer or as per manual process.

Ironically, many Indian banks are yet to take the required initiative for this purpose. One important reason for this is that the management of the banks has so far been in a protected environment with little exposure to the open market. Lack of technology and inadequate MIS, which prevented banks from moving towards effective ALM. The apathy on the part of the banks made it imperative for the RBI to step in and push the process.

The guidelines of RBI on ALM are primarily aimed to enable banks to tackle the liquidity risk and interest rate risk. For liquidity risk management, the assets and liabilities of the bank are segregated into different groups based on their maturity profile. Based on the maturity profile, the Statement of Structural Liquidity will have to be prepared by the banks. And to monitor the short-term liquidity, the banks are required to prepare the Statement of Short-term Dynamic Liquidity.

In a notification issued to commercial banks in the year 1998, RBI has pointed out as under:

"In the normal course, banks are exposed to credit and market risks in view of the asset-liability transformation. With liberalisation in Indian financial markets over the last few years and growing integration of domestic markets and with external markets, the risks associated with banks' operations have become complex and large, requiring strategic management. Banks are now operating in a fairly deregulated environment and are required to determine on their own, interest rates on deposits and advance in both domestic and foreign currencies on a dynamic basis. The interest rates on banks' investments in government and other securities are also now market related. 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. Imprudent liquidity management can put banks' earnings and reputation at great risk. 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 risk. It is, therefore, important that banks introduce effective risk management systems that address the issues related to interest rate, currency and liquidity risks.

"Banks need to address these risks in a structured manner by upgrading their risk management and adopting more comprehensive Asset-Liability Management (ALM) practices than has been done hitherto. ALM, among other functions, is also concerned with risk management and provides a comprehensive and dynamic framework for measuring, monitoring and managing liquidity, interest rate, foreign exchange and equity and commodity price risks of a bank that needs to be closely integrated with the banks' business strategy. It involves assessment of various types of risks and altering the asset-liability portfolio in a dynamic way in order to manage risks."

In this context RBI gave the following instructions with reference to implementation of the guidelines.

"Banks should give adequate attention to putting in place an effective ALM System. Banks should set up an internal Asset-Liability Committee (ALCO), headed by the CEO/CMD or the ED. The Management Committee or any specific Committee of the Board should oversee the implementation of the system and review its functioning periodically.

"Keeping in view the level of computerisation and the current MIS in banks, adoption of a uniform ALM System for all banks may not be feasible. The final guidelines have been formulated to serve as a benchmark for those banks, which lack a formal ALM System. Banks, which have already adopted more sophisticated systems, may continue their existing systems but they should ensure to fine-tune their current information and reporting system so as to be in line with the ALM System suggested in the Guidelines. Other banks should examine their existing MIS and arrange to have an information system to meet the prescriptions of the new ALM System. To begin with, banks should ensure coverage of at least 60% of their liabilities and assets. As for the remaining 40% of their assets and liabilities, banks may include the position based on their estimates. It is necessary that banks set targets in the interim, for covering 100 per cent of their business by April 1, 2000. The MIS would need to ensure that such minimum information/data consistent in quality and coverage is captured and once the ALM System stabilises and banks gain experience, they must be in a position to switch over to more sophisticated techniques like Duration Gap Analysis, Simulation and Value at Risk for interest rate risk management.”

Gist of the guidelines of RBI setting forth the outline and framework of the asset-liability management system are discussed in the next module.