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ASSET LIABILITY MANAGEMENT IN BANKS (ALM)
by
Rajesh Goyal
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What is Asset Liability Management or What is ALM ?
Asset liability management (ALM) can be defined as the comprehensive and dynamic framework for measuring, monitoring and managing the financial risks associated with changing interest rates, foreign exchange rates and other factors that can affect the organisation’s liquidity.
ALM relates to management of structure of balance sheet (liabilities and assets) in such a way that the net earning from interest is maximised within the overall risk-preference (present and future) of the institutions.
Thus the ALM functions includes the tools adopted to mitigating liquidly risk, management of interest rate risk / market risk and trading risk management. In short, ALM is the sum of the financial risk management of any financial institution.
In other words, ALM is all about managing three central risks: n Interest Rate Risk n Liquidity Risk n Foreign currency risk
For banks with forex operations, it also includes managing
n Currency risk
Through ALM banks try to match the assets and liabilities in terms of Maturities and Interest Rates Sensitivities so as to minimize the interest rate risk and liquidity risk.
Overview of what are asset liability mismatches : The Assets and Liabilities of the bank’s B/Sheet are nothing but future cash inflows & outflows. Under Asset Liability Management i.e. ALM, these inflows & outflows are grouped into different time buckets. Then each bucket of assets is matched with the corresponding bucket of liability. The differences in each bucket are known as mismatches.
Is complete matching of Assets & Liabilities in the Balance sheet necessary? No, because banks can even make money as a result of such mismatches sometimes. Alam Greenspan, ex-Chairman of US Federal Reserve has once observed “risk taking is necessary condition for wealth creation”. However, it is a risky proposition to keep large mismatches as it can lead to massive losses in a volatile market. Therefore, in practice, the idea is to limit the mismatches rather than aim at zero mismatches.
Evolution of ALM in Indian Banking System: In view of the regulated environment in India in 1970s to early 1990s, there was no interest rate risk as the interest rate were regulated and prescribed by RBI. Spreads between deposits and lending rates were very wide. At that time banks Balance Sheets were not being managed by banks themselves as they were being managed through prescriptions of the regulatory authority and the government. With the deregulation of interest rates, banks were given a large amount of freedom to manage their Balance sheets. Thus, it became necessary to introduce ALM guidelines so that banks can be prevented from big losses on account of wide ALM mismatches.
Reserve Bank of India issued its first ALM Guidelines in February 1999, which was made effective from 1 st April 1999. These guidelines covered, inter alia, interest rate risk and liquidity risk measurement/ reporting framework and prudential limits. Gap statements were required to be prepared by scheduling all assets and liabilities according to the stated or anticipated re-pricing date or maturity date. The Assets and Liabilities at this stage were required to be divided into 8 maturity buckets (1-14 days; 15-28 days; 29-90 days; 91-180 days; 181-365 days, 1-3 years and 3-5 years and above 5 years), based on the remaining period to their maturity (also called residual maturity).. All the liability figures were to be considered as outflows while the asset figures were considered as inflows.
As a measure of liquidity management, banks were required to monitor their cumulative mismatches across all time buckets in their statement of structural liquidity by establishing internal prudential limits with the approval of their boards/ management committees. As per the guidelines, in the normal course, the mismatches (negative gap) in the time buckets of 1-14 days and 15-28 days were not to exceed 20 per cent of the cash outflows in the respective time buckets Later on RBI made it mandatory for banks to form ALCO (Asset Liability Committee) as a Committee of the Board of Directors to track, monitor and report ALM.
It was in September, 2007, in response to the international practices and to meet the need for a sharper assessment of the efficacy of liquidity management and with a view to providing a stimulus for development of the term-money market, RBI fine tuned these guidelines and it was provided that the banks may adopt a more granular approach to measurement of liquidity risk by splitting the first time bucket (1-14 days at present) in the Statement of Structural Liquidity into three time buckets viz., 1 day (called next day) , 2-7 days and 8-14 days. Thus, banks were asked to put their maturing asset and liabilities in 10 time buckets.
Thus as per October 2007 RBI guidelines, banks were advised that the net cumulative negative mismatches during the next day, 2-7 days, 8-14 days and 15-28 days should not exceed 5%, 10%, 15% and 20% of the cumulative outflows, respectively, in order to recognize the cumulative impact on liquidity. Banks were also advised to undertake dynamic liquidity management and prepare the statement of structural liquidity on a daily basis. In the absence of a fully networked environment, banks were allowed to compile the statement on best available data coverage initially but were advised to make conscious efforts to attain 100 per cent data coverage in a timely manner. Similarly, the statement of structural liquidity was to be reported to the Reserve Bank, once a month, as on the third Wednesday of every month. The frequency of supervisory reporting of the structural liquidity position was increased to fortnightly, with effect from April 1, 2008. Banks are now required to submit the statement of structural liquidity as on the first and third Wednesday of every month to the Reserve Bank.
Board’s of the Banks were entrusted with the overall responsibility for the management of risks and required to decide the risk management policy and set limits for liquidity, interest rate, foreign exchange and equity price risks.
Asset-Liability Committee (ALCO), the top most committee to oversee the implementation of ALM system is to be headed by CMD /ED. ALCO considers product pricing for both deposits and advances, the desired maturity profile of the incremental assets and liabilities in addition to monitoring the risk levels of the bank. It will have to articulate current interest rates view of the bank and base its decisions for future business strategy on this view. Progress in Adoption of Techniques of ALM by Indian Banks : ALM process involve in identification , measurement and management of risk Parameter. In its original guidelines RBI asked the banks to use traditional techniques like Gap analysis for monitoring interest rates and liquidity risk. At that RBI desired that Indian Banks slowly move towards sophisticated techniques like duration , simulation and Value at risk in future. Now with the passage of time, more and more banks are moving towards these advanced techniques.
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Asset- Liability Management Techniques : ALM is bank specific control mechanism, but it is possible that several banks may employ similar ALM techniques or each bank may use unique system.
Gap Analysis : Gap Analysis is a technique of Asset – Liability management . It is used to assess interest rate risk or liquidity risk. It measures at a given point of time the gaps between Rate Sensitive Liabilities (RSL) and Rate Sensitive Assets (RSA) (including off balance sheet position) by grouping them into time buckets according to residual maturity or next re-pricing period , whichever is earlier. An asset or liability is treated as rate sensitive if;
i)Within time bucket under consideration is a cash flow. ii.) The interest rate resets/reprices contractually during time buckets iii.) Administered rates are changed and iv.) It is contractually pre-payable or withdrawal allowed before contracted maturities. Thus ; GAP=RSA-RSL GAP Ratio=RSAs/RSL • Mismatches can be positive or negative • Positive Mismatch: M.A.>M.L. and vice-versa for Negative Mismatch • In case of +ve mismatch, excess liquidity can be deployed in money market instruments, creating new assets & investment swaps etc. • For –ve mismatch,it can be financed from market borrowings(call/Term),Bills rediscounting,repos & deployment of foreign currency converted into rupee.
Gap analysis was widely used by financial institutions during late 1990s and early years of present century in India. The table below gives you idea who does a positive or negative gap would impact on NII in case there is upward or downward movement of interest rates:
Duration Gap Analysis : This is an alternative method for measuring interest-rate risk. This technique examines the sensitivity of the market value of the financial institution’s net worth to changes in interest rates. Duration analysis is based on Macaulay’s concept of duration, which measures the average lifetime of a security’s stream of payments. We know that Duration is an important measure of the interest rate sensitivity of assets and liabilities as it takes into account the time of arrival of cash flows and the maturity of assets and liabilities. It is the weighted average time to maturity of all the preset values of cash flows. Duration basically refers to the average life of the asset or the liability. DP /p =D ( dR /1+R) The above equation describes the percentage fall in price of the bond for a given increase in the required interest rates or yields. The larger the value of the duration, the more sensitive is the price of that asset or liability to changes in interest rates. Thus, as per this theory, the bank will be immunized from interest rate risk if the duration gap between assets and the liabilities is zero. The duration model has one important benefit. It uses the market value of assets and liabilities.
Duration analysis summarises with a single number exposure to parallel shifts in the term structure of interest rates. It can be noticed that both gap and duration approaches worked well if assets and liabilities comprised fixed cash flows. However options such as those embedded in mortgages or callable debt posed problems that gap analysis could not address. Duration analysis could address these in theory, but implementing sufficiently sophisticated duration measures was problematic.
Scenario Analysis : Under the scenario analysis of ALM several interest rate scenarios are created during next 5 to 10 years . Such scenarios might specify declining interest rates , rising interests rates, a gradual decrease in rates followed by sudden rise etc. Different scenarios may specify the behavior of the entire yield curve, so there could be scenarios with flattening yield curve, inverted yield curves etc. Ten to twenty scenarios might be specified to have a holistic view of the scnario analysis. Next assumptions would be made about the performances of assets and liabilities under each scenario. Assumptions might include prepayment rates on mortgages and surrender rates on insurance products. Assumptions may also be made about the firms performance . 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 scenario the ALCO might adjust assets or liabilities to address the indicated exposure . A short coming of scenario analysis is the fact that it is highly dependent on the choice of scenario. It also requires that many assumptions be made about how specific assets or liabilities will perform under specific scenario. Value at Risk VaR or Value ar Risk refers to the maximum expected loss that a bank can suffer over a target horizon, given a certain confidence interval. It enables the calculation of market risk of a portfolio for which no historical data exists. It enables one to calculate the net worth of the organization at any particular point of time so that it is possible to focus on long term risk implications of decisions that have already been taken or that are going to be taken. It is used extensively for measuring the market risk of a portfolio of assets and/or liabilities.
Conclusion: We can conclude to say that ALM is an important tool for monitoring, measuring and managing the interest rate risk, liquidity risk and foreign currency risk of a bank. With the deregulation of interest regime in India , the banking industry has been exposed to interest rate risk / market risk . Hence to manage such risk, ALM needs to be used so that the management is able to assess the risks and cover some of these by taking appropriate decisions.
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