Module: 3 - Guidelines of RBI to Commercial Banks for Adoption of ALM System

ALM model recommended by RBI to commercial banks is based on three pillars.

1. ALM Information Systems

   1. Management Information Systems

   2. Information availability, accuracy, adequacy and expediency

2. ALM Organisation

   1. Structure and responsibilities

   2. Level of top management involvement

3. ALM Process

   1. Risk parameters

   2. Risk identification

   3. Risk measurement

   4. Risk management

   5. Risk policies and tolerance levels.

ALM has to be supported by a management philosophy which clearly specifies the risk policies and tolerance limits. This framework needs to be built on sound methodology with necessary information system as back up. Thus, information is the key to the ALM process. It is, however, recognised that varied business profiles of banks in the public and private sector as well as those of foreign banks do not make the adoption of a uniform ALM System for all banks feasible. There are various methods prevalent worldwide for measuring risks. These range from the simple Gap Statement to extremely sophisticated and data intensive Risk Adjusted Profitability Measurement methods. However, the central element for the entire ALM exercise is the availability of adequate and accurate information with expedience and the existing systems in many Indian banks do not generate information in the manner required for ALM. Collecting accurate data in a timely manner will be the biggest challenge before the banks, particularly those having wide network of branches but lacking full-scale computerisation. However, the introduction of base information system for risk measurement and monitoring has to be addressed urgently. As banks are aware, internationally, regulators have prescribed or are in the process of prescribing capital adequacy for market risks. A pre-requisite for this is that banks must have in place an efficient information system.

Successful implementation of the risk management process would require strong commitment on the part of the senior management in the bank, to integrate basic operations and strategic decision making with risk management. The Board should have overall responsibility for management of risks and should decide the risk management policy of the bank and set limits for liquidity, interest rate, foreign exchange and equity price risks.

The Asset - Liability Committee (ALCO) consisting of the bank's senior management including CEO should be responsible for ensuring adherence to the limits set by the Board as well as for deciding the business strategy of the bank (on the assets and liabilities sides) in line with the bank's budget and decided risk management objectives.

The ALCO is a decision-making unit responsible for balance sheet planning from risk -return perspective including the strategic management of interest rate and liquidity risks. Each bank will have to decide on the role of its ALCO, its responsibility as also the decisions to be taken by it. The business and risk management strategy of the bank should ensure that the bank operates within the limits / parameters set by the Board. The business issues that an ALCO would consider, inter alia, will include product pricing for both deposits and advances, desired maturity profile and mix of the incremental assets and liabilities, etc. 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 funding mixes 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.

The ALM Support Groups consisting of operating staff should be responsible for analysing, monitoring and reporting the risk profiles to the ALCO. The staff should also prepare forecasts (simulations) showing the effects of various possible changes in market conditions related to the balance sheet and recommend the action needed to adhere to bank's internal limits.

The Management Committee of the Board or any other Specific Committee constituted by the Board should oversee the implementation of the system and review its functioning periodically.

The scope of ALM function can be described as follows:

• Liquidity risk management

• Management of market risks

• Trading risk management

• Profit planning and growth projectio

However the guidelines given by RBI 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. RBI has also provided a standard format for calculating Structural Liquidity.

The guidelines provide detailed Maturity Profile in respect of different categories of assets and liabilities for measuring the future cash flows of banks in different time buckets. The range of different time buckets classified is as under:

• 1 to 14 days

• 15 to 28 days

• 29 days and upto 3 months

• Over 3 months and upto 6 months

• Over 6 months and upto 1 year

• Over 1 year and upto 3 year

• Over 3 years and upto 5 year

• Over 5 years

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.

The 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 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 for estimating Short-term Dynamic Liquidity.

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 daytime 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 capital to Risk-Weighted Assets Ratio of 8% 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 issued by RBI, Exchange Control Department contained in Circular A.D (M. A. Series) No.52 dated December 27, 1997

The phased deregulation of interest rates and the operational flexibility given to banks in pricing most of the assets and liabilities imply the need for the banking system to hedge the Interest Rate Risk. Interest rate risk is the risk where changes in market interest rates might adversely affect a bank's financial condition. The changes in interest rates affect banks in a larger way. The immediate impact of changes in interest rates is on bank's earnings (i.e. reported profits) by changing its Net Interest Income (NII). A long-term impact of changing interest rates is on bank's Market Value of Equity (MVE) or Net Worth as the economic value of bank's assets, liabilities and off-balance sheet positions get affected due to variation in market interest rates. The interest rate risk when viewed from these two perspectives is known as 'earnings perspective' and 'economic value' perspective, respectively. The risk from the earnings perspective can be measured as changes in the Net Interest Income (NII) or Net Interest Margin (NIM). There are many analytical techniques for measurement and management of Interest Rate Risk. In the context of poor MIS, slow pace of computerisation in banks and the absence of total deregulation, the traditional Gap analysis is considered as a suitable method to measure the Interest Rate Risk in the first place. It is the intention of RBI to move over to the modern techniques of Interest Rate Risk measurement like Duration Gap Analysis, Simulation and Value at Risk over time when banks acquire sufficient expertise and sophistication in acquiring and handling MIS.The Gap or Mismatch risk can be measured by calculating Gaps over different time intervals as at a given date. Gap analysis measures mismatches between rate sensitive liabilities and rate sensitive assets (including off-balance sheet positions). An asset or liability is normally classified as rate sensitive if:

• Within the time interval under consideration, there is a cash flow;

• The interest rate resets/reprices contractually during the interval;

• RBI changes the interest rates (i.e. interest rates on Savings Bank Deposits, DRI advances, Export credit, Refinance, CRR balance, etc.) in cases where interest rates are administered; and

• It is contractually pre-payable or withdrawal before the stated maturities.

The Gap Report should be generated by grouping rate sensitive liabilities, assets and off-balance sheet positions into time buckets according to residual maturity or next repricing period, whichever is earlier. The difficult task in Gap analysis is determining rate sensitivity. All investments, advances, deposits, borrowings, purchased funds, etc. that mature/reprice within a specified timeframe are interest rate sensitive. Similarly, any principal repayment of loan is also rate sensitive if the bank expects to receive it within the time horizon. This includes final principal payment and interim instalments. Certain assets and liabilities receive/pay rates that vary with a reference rate. These assets and liabilities are repriced at pre-determined intervals and are rate sensitive at the time of repricing. While the interest rates on term deposits are fixed during their currency, the advances portfolio of the banking system is basically floating. The interest rates on advances could be repriced any number of occasions, corresponding to the changes in PLR.

The Gaps may be identified in the following time buckets

1. 1-28 days

2. 29 days and upto 3 months

3. Over 3 months and upto 6 months

4. Over 6 months and upto 1 year

5. Over 1 year and upto 3 years

6. Over 3 years and upto 5 years

7. Over 5 years

8. Non-sensitive

The various items of rate sensitive assets and liabilities and off-balance sheet items may be classified as per schedule given by RBI with the guidelines (Appendix - II) and the Reporting Format for interest rate sensitive assets and liabilities to be made in the format provided (Annexure II)

The Gap is the difference between Rate Sensitive Assets (RSA) and Rate Sensitive Liabilities (RSL) for each time bucket. The positive Gap indicates that it has more RSAs than RSLs whereas the negative Gap indicates that it has more RSLs. The Gap reports indicate whether the institution is in a position to benefit from rising interest rates by having a positive Gap (RSA > RSL) or whether it is in a position to benefit from declining interest rates by a negative Gap (RSL > RSA). The Gap can, therefore, be used as a measure of interest rate sensitivity.

Each bank should set prudential limits on individual Gaps with the approval of the Board/Management Committee. The prudential limits should have a bearing on the Total Assets, Earning Assets or Equity. The banks may work out Earnings at Risk (EaR) or Net Interest Margin (NIM) based on their views on interest rate movements and fix a prudent level with the approval of the Board/Management Committee.

RBI will also introduce capital adequacy for market risks in due course.

The classification of various components of assets and liabilities into different time buckets for preparation of Gap reports (Liquidity and Interest Rate Sensitivity) as indicated in Appendices I & II is the benchmark. Banks which are better equipped to reasonably estimate the behavioural pattern, embedded options, rolls-in and rolls-out, etc of various components of assets and liabilities on the basis of past data / empirical studies could classify them in the appropriate time buckets, subject to approval from the ALCO / Board. A copy of the note approved by the ALCO / Board may be sent to the Department of Banking Supervision.

The present framework does not capture the impact of embedded options, i.e. the customers exercising their options (premature closure of deposits and prepayment of loans and advances) on the liquidity and interest rate risks profile of banks. The magnitude of embedded option risk at times of volatility in market interest rates is quite substantial. Banks should therefore evolve suitable mechanism, supported by empirical studies and behavioural analysis to estimate the future behaviour of assets, liabilities and off-balance sheet items to changes in market variables and estimate the embedded options.

A scientifically evolved internal transfer pricing model by assigning values on the basis of current market rates to funds provided and funds used is an important component for effective implementation of ALM System. The transfer price mechanism can enhance the management of margin i.e. lending or credit spread, the funding or liability spread and mismatch spread. It also helps centralising interest rate risk at one place, which facilitate effective control and management of interest rate risk. A well-defined transfer pricing system also provides a rational framework for pricing of assets and liabilities.