This presentations chalks out in detail information about ALM in Indian Bank. It starts with the basics of Balance sheet; applicability of ALM in real life; Evolution and then starts with main topics of ALM like structured statement; Liquidity risk, its management; currency risk and finally ends with Interest Risk management. Links to Video’s in the ppt Balance Sheet http://www.investopedia.com/terms/b/balancesheet.asp NII/NIM http://www.investopedia.com/terms/n/netinterestmargin.asp www.abhijeetdeshmukh.com

1. Asset Liability
Management (ALM) in
Banks
ABHIJEET V DESHMUKH
www.abhijeetdeshmukh.com

2. Balance Sheet
 A financial statement that summarizes a company's assets, liabilities and
shareholders' equity at a specific point in time. These three balance sheet
segments give investors an idea as to what the company owns and owes, as well
as the amount invested by shareholders.
 The balance sheet adheres to the following formula:
Assets = Liabilities + Shareholders' Equity

3. Components of a Bank Balance Sheet
Liabilities Assets
1. Capital
2. Reserve & Surplus
3. Deposits
4. Borrowings
5. Other Liabilities
1. Cash & Balances with RBI
2. Bal. With Banks & Money at
Call and Short Notices
3. Investments
4. Advances
5. Fixed Assets
6. Other Assets
A Bank’s profit & Loss Account has the following components:
I. Income: This includes Interest Income and Other Income.
II. Expenses: This includes Interest Expended, Operating Expenses and
Provisions & contingencies.

4. Introduction to ALM
 A monthly mortgage is a common example of a liability that a consumer has to fund out of
his or her current cash inflow.
 Each month, the individual faces the task of having sufficient assets to pay that mortgage.
 For e.g. if Joe in the example is not able to generate enough funds through Pizza delivery
he wont be able to pay his Car Mortgage. Slowly his Net Worth will be wiped out and his
assets wont be able to support his liabilities.

5. Bank have similar challenges, but on a much more complex scale.
 Consider a bank that borrows USD 100MM at 3.00% for a year and lends the same
money at 3.20% to a highly-rated borrower for 5 years.
 The net transaction appears profitable—the bank is earning a 20 basis point
spread—but it entails considerable risk.
 At the end of a year, the bank will have to find new financing for the loan, which
will have 4 more years before it matures.
 If interest rates have risen, the bank may have to pay a higher rate of interest on
the new financing than the fixed 3.20 it is earning on its loan.
 Suppose, at the end of a year, an applicable 4-year interest rate is 6.00%. The
bank is in serious trouble. It is going to be earning 3.20% on its loan and paying
6.00% on its financing.
 The problem in this example was caused by a mismatch between assets and
liabilities.
Example

6. What is Asset Liability Management?
 In its simplest form, asset/liability management entails managing assets and cash inflows to
satisfy various obligations/liabilities/cash outflows.
 Some prefer the phrase "surplus/Net Worth optimization" as better term to explain the
need to maximize assets available to meet increasingly complex liabilities.
 It is a form of risk (credit risk, interest risk, and liquidity risk) management whereby one
endeavors to mitigate or hedge the risk of failing to meet these obligations.
 An effective Asset Liability Management Technique aims to manage the volume, mix,
maturity, rate sensitivity, quality and liquidity of assets and liabilities as a whole so as to
attain a predetermined acceptable risk/reward ratio
 Asset-liability management models enable institutions to measure and monitor risk, and
provide suitable strategies for their management.
 ALM Process stabilizes short-term profits, long-term earnings and long-term substance of
the bank and thus increases Bank’s Profit, in addition to managing risk

7. ALM must strike a balance…
Company
Objectives
Risk Tolerance
Shareholder
Expectations
Regulatory
Requirements
Accounting
Requirements
Investment
Markets
Policyholder
Interests

8. Evolution
 In the 1940s and the 1950s, there was an abundance of funds in banks in the form of
demand and savings deposits & Fed monetary policy kept interest rates stable. Hence, the
focus then was mainly on asset management.
 As loan demand increased in the 1960s during bouts of inflation associated with the
Vietnam War, banks for first time started to use liability management.
 Things started to change in the 1970s, which was a period of volatile interest rates that
continued into the early 1980s.
 Late 1980’s, the availability of low cost funds started to decline, along with volatility of
interest rates in USA and Europe caused the focus to broaden to include the issue of
interest rate risk.
 In 21st century, Globalization of financial markets, Deregulation of Interest Rates, Multi-
currency Balance Sheet, Prevalence of Inverted Curve, Basis Risk and Embedded Option Risk
& Integration of Markets – Money Market, Forex Market, Government Securities Market,
ALM began to extend beyond the bank treasury to cover the loan and deposit functions
and thus the management of both sides of the balance sheet

9. Parameters for stabilizing ALM
 Net Interest Income (NII)
= Interest Income-Interest Expenses.
 Net Interest Margin (NIM)
= Net Interest Income/Average Total/Earning Assets
 Economic Equity Ratio
The ratio of the shareholders funds to the total assets measures the
shift in the ratio of owned funds to totals funds .This fact assesses the
sustainability / capacity of the bank.

10. Three Tools used by banks for ALM
ALM Information System
ALM Organization
ALM Process

11. ALM Information Systems
 Usage of Real Time information system to gather the information about the
maturity and behavior of loans and advances made by all other branches of a
bank
 ABC Approach :
 analysing the behaviour of asset and liability products in the top branches as
they account for significant business
 then making rational assumptions about the way in which assets and liabilities
would behave in other branches
 The data and assumptions can then be refined over time as the bank
management gain experience
 The spread/speed of computerisation will also help banks in accessing data.

12. ALM Organization
 The board should have overall responsibilities and should set the limit for liquidity, interest
rate, foreign exchange and equity price risk
 The Asset - Liability Committee (ALCO)
 ALCO, consisting of the bank's senior management (including CEO) should be
responsible for ensuring adherence to the limits set by the Board
 Is responsible for balance sheet planning from risk - return perspective including the
strategic management of interest rate and liquidity risks
 The role of ALCO includes product pricing for both deposits and advances, desired
maturity profile of the incremental assets and liabilities,
 It will have to develop a view on future direction of interest rate movements and decide
on a funding mix between fixed vs floating rate funds, wholesale vs retail deposits,
money market vs capital market funding, domestic vs foreign currency funding
 It should review the results of and progress in implementation of the decisions made in
the previous meetings

13. ALM Process
Risk Parameters
Risk Identification
Risk Measurement
Risk Management
Risk Policies and Tolerance
Level

14. Categories of Risk
 Risk is the chance or probability of loss or damage
Credit Risk Market Risk Operational Risk
Transaction Risk /default risk
/counterparty risk
Commodity risk Process risk
Portfolio risk /Concentration risk Interest Rate risk Infrastructure risk
Settlement risk Forex rate risk Model risk
Equity price risk Human risk
Liquidity risk

15. Risks managed by ALM are….
Will now be discussed in detail
Interest
Rate Risk
Currency
Risk
Liquidity
Risk

16. Liquidity Risk
Definition
 Liquidity risk refers to the risk that the institution might not be able to generate
sufficient cash flow to meet its financial obligations
Effect
 Risk to bank’s earnings
 Reputational risk
 Contagion effect
 Liquidity crisis can lead to runs on Banks & their failures can affect Global
economies

17. Factors affecting Liquidity Risk
 Over extension of credit
 High level of NPAs
 Poor AML Policy
 Poor asset quality
 Mismanagement
 Reliance on a few wholesale depositors
 Large undrawn loan commitments
 Lack of appropriate liquidity policy & contingent plan

18. Liquidity Risk
 Liquidity risk arises from funding of long term assets by short term liabilities, thus
making the liabilities subject to refinancing
• Arises due to unanticipated withdrawals of the
deposits from wholesale or retail clients
Funding risk
• It arises when an asset turns into a NPA. So, the
expected cash flows are no longer available to
the bank.
Time risk
• Due to crystallisation of contingent liabilities
(e.g. Law suite expense) or new demand of
loans, Bank is unable to undertake profitable
business opportunities when available.
Call Risk

19. Liquidity Risk Management
 Bank’s liquidity management is the process of generating funds to meet contractual or
relationship obligations at reasonable prices at all times. It can be managed from either the
asset side of the balance sheet or the liability side.
 Asset based management
 Main goal is storing liquidity in the form of liquid assets.
 Less risky and often used by smaller institutions
 Costs
 Opportunity cost of foregone earnings if sold
 Transaction Costs
 Weakened Balance Sheet as it’s a substitution to a high yield long term asset
 Liability based management - Raising funds via borrowing if needed
 Only borrow if funds are needed
 Volume and composition of asset portfolio is unchanged
 Can always attract funds (by increasing rate)

20. Statement of Structural Liquidity
All Assets & Liabilities to be reported as per their maturity profile into 8 maturity
Buckets:
i. 1 to 14 days
ii. 15 to 28 days
iii. 29 days and up to 3 months
iv. Over 3 months and up to 6 months
v. Over 6 months and up to 1 year
vi. Over 1 year and up to 3 years
vii. Over 3 years and up to 5 years
viii. Over 5 years

21. Statement of Structural Liquidity
 Places all cash inflows and outflows in the maturity ladder as per residual
maturity
 Maturing Liability: Cash Outflow
 Maturing Assets : Cash Inflow
 Classified in to 8 time buckets
 Mismatches in the first two buckets not to exceed 20% of outflows
 Shows the structure as of a particular date
 Banks can fix higher tolerance level for other maturity buckets.

22. An Example of Structural Liquidity Statement
1-14 Days 15-28
Days
30 Days-3
Month
3 - 6
Months
6 Months -
1Year
1 - 3 Years
Years
3 - 5
Years
Over 5 Years
Years
Total
Capital 200 200
Liab-fixed Int 300 200 200 600 600 300 200 200 2600
Liab-floating Int 350 400 350 450 500 450 450 450 3400
Others 50 50 0 200 300
Total outflow 700 650 550 1050 1100 750 650 1050 6500
Investments 200 150 250 250 300 100 350 900 2500
Loans-fixed Int 50 50 0 100 150 50 100 100 600
Loans - floating int 200 150 200 150 150 150 50 50 1100
Loans BPLR Linked 100 150 200 500 350 500 100 100 2000
Others 50 50 0 0 0 0 0 200 300
Total Inflow 600 550 650 1000 950 800 600 1350 6500
Gap (100.00) (100.00) 100.00 (50.00) (150.00) 50.00 (50.00) 300.00 -
Cumulative Gap (100.00) (200.00) (100.00) (150.00) (300.00) (250.00) (300.00) - -

23. Addressing the Mismatches
 Mismatches can be positive or negative
 Positive Mismatch: M.A. > M.L. and
 Negative Mismatch M.L. > M.A.
 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.

24. Currency Risk
 The increased capital flows from different nations following deregulation have
contributed to increase in the volume of transactions
 Dealing in different currencies brings opportunities as well as risk
 To prevent this banks have been setting up overnight limits and undertaking
active day time trading
 Value at Risk approach to be used to measure the risk associated with forward
exposures. Value at Risk estimates probability of portfolio losses based on the
statistical analysis of historical price trends and volatilities.

25. Interest Rate Risk
 Interest Rate risk is the exposure of a bank’s financial conditions to adverse
movements of interest rates which can pose a significant threat to a bank’s
earnings and capital base
 Changes in interest rates also affect the underlying value of the bank’s assets,
liabilities and off-balance-sheet item
 Interest rate risk refers to volatility in Net Interest Income (NII) or variations in
Net Interest Margin(NIM)
 Therefore, an effective risk management process that maintains interest rate risk
within prudent levels is essential to safety and soundness of the bank.

26. Sources of Interest Rate Risk
Interest
Rate
Risk
Basis
Gap/ Re-
pricing
Yield
(Price & Reinvestment)
Options

27.  Gap / Re-pricing Risk: The assets and liabilities could re-price at different dates and
might be of different time period. For example, a loan on the asset side could re-price
at three-monthly intervals whereas the deposit could be at a fixed interest rate or a
variable rate, but re-pricing half-yearly
 Basis Risk: The assets could be based on LIBOR rates whereas the liabilities could be
based on Treasury rates or a Swap market rate i.e. interest rate of different assets and
liabilities may change in different magnitudes
 Yield Curve Risk: The changes are not always parallel but it could be a twist around a
particular tenor and thereby affecting different maturities differently. LT securities are
more sensitive to Interest risk. Prices of bonds are inversely related to Yield and
Reinvestment of coupon during low rate fall may happen at lower rate
 Option Risk: Exercise of options impacts the financial institutions by giving rise to
premature release of funds that have to be deployed in unfavourable market
conditions and loss of profit on account of foreclosure of loans that earned a good
spread.
Sources of Interest Rate Risk

28. Risk Measurement Techniques
Various techniques for measuring exposure of banks to interest rate risks. To
mitigate interest rate risk, the structure of the balance sheet has to be managed in
such a way that the effect on assets of any movement in Interest rates remains
highly correlated with its effect on Liabilities, even in Volatile interest rate
environments.
 Maturity Gap Analysis (IRS)
 Duration
 Simulation
 Value at Risk

29. Maturity Gap Method (IRS)
Three Options:
 A) Rate Sensitive Assets > Rate Sensitive Liabilities = Positive Gap
 B) Rate Sensitive Assets < Rate Sensitive Liabilities = Negative Gap
 C) Rate Sensitive Assets = Rate Sensitive Liabilities = Zero Gap

30. What Determines Rate Sensitivity?
 An asset or liability is considered rate sensitivity if during the time interval:
 It matures
 It represents and interim, or partial, principal payment
 It can be re-priced
 The interest rate applied to the outstanding principal changes
contractually during the interval
 The outstanding principal can be re-priced when some base rate of index
changes and management expects the base rate / index to change
during the interval

31. Interest-Sensitive Assets & Liabilities
Interest Sensitive Assets
 Short-Term Securities Issued by the Government and Private Borrowers
 Short-Term Loans Made by the Bank to Borrowing Customers
 Variable-Rate Loans Made by the Bank to Borrowing Customers
Interest Sensitive Liabilities
 Borrowings from Money Markets
 Short-Term Savings Accounts
 Money-Market Deposits
 Variable-Rate Deposits

32. Example
 A bank makes a $10,000 four-year car loan to a customer at fixed rate of 8.5%.
The bank initially funds the car loan with a one-year $10,000 CD at a cost of
4.5%. The bank’s initial spread is 4%.
 What is the bank’s one year gap?
 RSA1yr = $0
 RSL1yr = $10,000
 GAP1yr = $0 - $10,000 = -$10,000
 The bank’s one year funding GAP is -10,000
 If interest rates rise (fall) in 1 year, the bank’s margin will fall (rise)
4 year Car Loan 8.50%
1 Year CD 4.50%
4.00%

33. Gap Analysis
 Simple maturity/re-pricing Schedules can be used to generate simple indicators
of interest rate risk sensitivity of both earnings and economic value to changing
interest rates
- If a negative gap occurs (RSA<RSL) in given time band, an increase in market
interest rates could cause a decline in NII
- conversely, a positive gap (RSA>RSL) in a given time band, an decrease in
market interest rates could cause a decline in NII
 The basic weakness with this model is that this method takes into account only
the book value of assets and liabilities and hence ignores their market value.

34. Measuring Interest Rate Risk with GAP
 Traditional Static GAP Analysis
GAPt = RSAt – RSLt
 RSAt (Rate Sensitive Assets)
 Those assets that will mature or reprice in a given time period (t)
 RSLt (Rate Sensitive Liabilities)
 Those liabilities that will mature or reprice in a given time period (t)

35.  It is the weighted average time to maturity of all the preset values of cash flows
 It basically refers to the average life of the asset or the liability
 Duration Measures the sensitivity of the value of a series of cash flows to changes
in interest rates. It is approximately the average point at which the projected cash
flows occur.
 For example, if a portfolio of assets has a duration of 4, a 1% increase in interest
rates will cause a 4% decrease in its value
 The larger the value of the duration, the more sensitive is the price of that asset
or liability to changes in interest rates
 As per the above equation, the bank will be immunized from interest rate risk if
the duration gap between assets and the liabilities is zero.
Duration Analysis

36. Simulation
 Basically simulation models utilize computer power to provide what if scenarios,
for example: What if:
 The absolute level of interest rates shift
 Marketing plans are under-or-over achieved
 Margins achieved in the past are not sustained/improved
 Bad debt and prepayment levels change in different interest rate scenarios
 There are changes in the funding mix e.g.: an increasing reliance on short-
term funds for balance sheet growth
 This dynamic capability adds value to this method and improves the quality of
information available to the management

37. Value at Risk (VaR)
 Refers to the maximum expected loss that a bank can suffer in market value or
income:
 Over a given time horizon,
 Under normal market conditions,
 At a given level or certainty
 It enables the calculation of market risk of a portfolio for which no historical
data exists. VaR serves as Information Reporting to stakeholders
 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

38. Thank You