Capital Structure & Asset Liability Management
[By Ms. Sailashree, PG Student, IIT, Roorke]

Preface

The advent of comprehensive reforms in the banking and financial sectors, the deregulation and opening of the Indian economy to the global market changed totally the structure and functional environment of banking in India today. These are discussed earlier in detail in the module Indian Banking Today and Tomorrow.

The advent of Reforms in the Financial & Banking Sectors (the first phase in the year 1992 to 1995) and the second phase in 1998 heralds a new welcome development to reshape and reorganise banking institutions to look forward to the future with competence and confidence. The complete freeing of Nationalised Banks (the major segment) from administered policies and Government regulation in matters of day to day functioning heralds a new era of self-governance and a scope for exercise of self initiative for these banks. There will be no more directed lending, pre-ordered interest rates, or investment guidelines as per dictates of the Government or RBI. Banks are to be managed by themselves, as independent corporate organizations, and not as extensions of government departments. Acceptance of prudential norms with regards to Capital Adequacy, Income Recognition and Provisioning are welcome measures of self regulation intended to fine-tune growth and development of the banks. It introduces a new transparency, and the balance sheets of banks now convey both their strength and weakness. Capital Adequacy and provisioning norms are intended to provide stability to the Banks and protect them in times of crisis. These equally induce a measure of corporate accountability and responsibility for good management on the part of the banks

Along with new opportunities banks increasingly now face new challenges in the aftermath of captive insulated well-protected banking of the pre-reform era. There is keen competition with new players, who have set up their establishments with modern technology. In the new deregulated environment the intermediation activity of the banks exposes them to various risks not by chance but by choice.

The price at which the banks mobilize and transfer funds depends essentially on two parameters - the time for which the funds are made available and the credit worthiness of the person to whom the funds are made available. Considering that the long-term transfer of funds are priced higher than short-term funds and a high risk borrower pays high interest rate, banks will have to take liquidity risk and/or credit risk to earn the spreads. There is also a definite linkage between the various risks faced by banks. For example, if the bank charges its client a floating rate of interest, in cases of increasing interest rate scenario, the bank's interest rate risk will be lower. Consequently, the payment obligation of the borrower increases. Other things remaining constant, the default risk increases if the client is not able to bear the burden of the rising rates. There are many instances where the interest rate risk eventually leads to credit risk.

ALM risk is another threat the banker has to guard off with continuous vigilance. Asset-liability risk is a leveraged form of market risk. Because the capital (surplus) of a financial firm such as a bank or insurance company is small relative to its assets or liabilities, small percentage changes in assets or liabilities can translate into large percentage changes in capital. Consider the evolution over time of a hypothetical company's assets and liabilities. Over the period , the assets and liabilities may change only slightly, but those slight changes dramatically alter the company's capital (which is just the difference between assets and liabilities). In this example if the capital falls by over 50% for an erosion in assets by 10%, a development that would threaten almost any institution.

Banks and Insurance Companies address this risk by structuring their assets to hedge their liabilities. For example, if a liability represents a long-dated fixed income obligation, a company might hold long bonds as a hedging asset. In this way, changes in the value of the liability are mirrored by changes in the value of the assets, and capital-the difference between the two-is unaffected.

Internationally banks have come to realise that in the competitive era of banking, securing adequate capital and ever guarding the adequacy of capital through prudential norms and risk containment practices are the only sure ways to face the onset of new emerging challenges. The project discusses aptly the capital structure of Indian Banking system and about the most common risk that the bank would face in the new environment i.e. Risk of Asset-Liability Mismatch and prescribes standards approved by the market regulator, the RBI.

The two projects-

1. Capital structure, and

2. Asset, Liability Management, in selected banks in India

are contributed by a PG student from IIT Roorke, Ms.Sailashree