This is a simple introduction to the vast subject of Asset Liability Management in Banks

1. RISK IN BALANCE SHEET OF
A BANK- INTRODUCTION TO
ALM
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India >> Forward
K. R. Chandra

2. WHAT IS ALM
ALM is the process involving
decision making about the
composition of assets and
liabilities including off balance
sheet items of the bank and
conducting the risk
2

3. WHAT IS ALM- CONTD….
Concerned with strategic Balance Sheet management
Match between assets and liabilities in BS
Risks stem from mismatch between A&L – credit, liquidity, interest, currency
ALM is not to avoid risk but to manage risk, sustaining profitability
•Periodic monitoring of risk exposures involving collecting and analyzing information
•Ability to anticipate, forecast and act so as to structure bank’s business to profit
•Altering A & L portfolio in a dynamic way to manage risks
•Involves judgment and decision making
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4. WHY ALM
Globalization of financial markets.
Deregulation of Interest Rates.
Multi-currency Balance Sheet.
Integration of Markets – Money
Market, Forex Market, Government
Securities Market.
Narrowing NII / NIM
4

5. COMPONENTS OF A
BANK BALANCE SHEET
5
Liabilities Assets
1. Capital
2. Reserve & Surplus
3. Deposits
4. Borrowings
5. Other Liabilities & provisions
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

6. BOOK VALUE VRS. MARKET VALUE
ACCOUNTING
A bank borrows Rs.10 Crore at 3.00% for a year and lends the same
money at 3.20% for 5 years.
At the end of a year, an applicable 4-year interest rate is 6.00%
Book(Accrual) Value Accounting: Asset 10 cr.X 1.032= Rs.10.32 crore
Liability 10 cr.X1.03=Rs.10.30 crore. Hence profit- 2 lakh
Market Value Accounting : Asset 10 cr.X (1.032)5/(1.06)4 = Rs.9.27cr
Liability 10 cr.X1.03=Rs.10.30 crore. Hence loss- Rs. 1.03 cr.
6

7. LET US READ MARKET’S MIND
Two groups of people in the financial market – lenders & borrowers
Borrowers prefer longer time frame
Lenders prefer shorter timer frame (liquidity preference)
Banks assume the role of a intermediary between lenders & Borrowers
(accepting deposits & issuing loans)
Hence bankers’ liabilities are short term in nature & assets are long term in
nature
Result - LT interest rates exceed ST interest rates
Incentive for Banks for performing the intermediation role = Interest
Spread
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8. INTERMEDIATION FUNCTIONS
OF BANKS
Banks perform various types of intermediation functions :
1.Denomination Intermediation
- Banks pool funds from small depositors
- Issue larger loans to big customers / industries
– This leads to Liquidity Risk
2.Default Risk Intermediation :
- Banks mobilise deposits by issuing safe and liquid securities (FDRs)
- Providing loans to risky borrowers by taking relatively less safe and less
liquid securities (Guarantee / Mortgage).
- This leads to credit risk.
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9. INTERMEDIATION FUNCTIONS OF
BANKS-CONTD..
3.Maturity Intermediation :
Accepting deposits from savers for a comparatively shorter period
of time
Issuing long term loans to borrowers
Results in Interest Rate Risk
ST funds invested in LT loans / LT funds invested in ST loans
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10. WHAT IS RISK
Deviations from planned
Uncertainty resulting in adverse outcome
Financial risk: uncertainty resulting in adverse variation of profitability or
outright loss
Uncertainty impact the variation in net cash flow favorably or unfavorably
Lower risk implies lower variability with lower upside or downside potential
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11. Survival of organization in severe adverse
conditions
Cash flows effected resulting in high loss to wipe
out the capital/ bankruptcy
Can be avoided if, loss potential can be controlled
Loss potential is correlated to uncertainties of
business ie risk in the business
Develop method to measure risk, awareness to risk
& potential loss from risk.
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Why Manage risk?

12. To determine adequate capital for continuance or
limit its risk exposure to the extent of capital
available.
Loss out of business has to be accounted for by
factoring it in to pricing.
Over estimation or underestimation of risk may
result into over pricing or underpricing impacting
the business.
Controlling the level of risk to the organisations
capacity to bear the risk.
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Why Manage risk?- contd….

13. Liquidity Risk: LT asset by ST Liabilities
Funding risk: unanticipated withdrawal/ non
renewal of deposits
Time risk: non receipt of expected inflow
Call risk: Crystalisation of contingent liabilities
Banks face 4 Basic financial risk
Credit risk, Interest rate risk, Foreign exchange
risk and Liquidity risk
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Different risks???

14. Credit Risk – loss arising on account of default in repayment
Interest rate Risk – Risk of loss arising on account of changes in the market
interest rates
Liquidity Risk – Inability to generate cash to meet the requirements, mismatch
in maturity pattern of assets and liabilities
Capital Risk – Inability to maintain adequate capital on continuous basis to
meet risk, statutory requirement, business needs etc.
Market Risk – Adverse impact on financial condition due to adverse movement
in market prices
Exposure Risk – Risk due to large exposure to single party/sector
Operational Risk – Risk arising on account of failed internal control, processes,
systems etc.
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Different risk in Banks

15. RISK MANAGEMENT IN BANKS- CASE EXERCISE-
1
Assets (million Rs.) Liabilities (million Rs.)
100 (5 years fixed rate 90 (30 day deposits @ 4 %)
loan @ 8 %)
Equity 10
Total 100 100
NII = 8.00-3.6 = 4.4 million Rs.
NIM = 4.4/100 = 4.4 %

16. RISK MANAGEMENT IN BANKS- CASE EXERCISE-
2
If market rate of interest increases by 200 basis point from 4 % to 6
%, what would be its impact on NII and NIM?
The cost of the short term borrowing will increase, but the interest
income from long term fixed rate loan will remain unchanged.

17. RISK MANAGEMENT IN BANKS- CASE EXERCISE-
3
Interest expenses will increase from 3.6 million to 5.4 million
Interest income is not effected because all the loans are at long term
fixed rate.
In this case, NII falls to 2.6 million (8.00-5.4 = 2.6) and,
NIM = 2.6/100 = 2.6 per cent

18. RISK MANAGEMENT IN BANKS- CASE EXERCISE-
4
If the bank had made the loans at a variable (floating) rate, then with
increase in interest rate by 200 basis point, what would be the impact
on NII and NIM?
NII = 10.00-5.4 = 4.6
NIM = 4.6/100 = 4.6 percent

19. RISK MANAGEMENT IN BANKS
Banks make loans and raise funds with many different maturities and
interest rates
Therefore NII and NIM depend on
Interest rate earned on assets and paid for funds
The amount and composition of various earning assets and liabilities

20. By attempting to match the assets and liabilities
 in terms of their maturities and interest rate sensitivities
 To contain the risk arising from such mismatches within the desired level
By controlling volatility of
 Net Interest Income
 Net Income,
 Net Interest Margin
 to have an acceptable balance between profitability, growth and risk
 By controlling liquidity risk
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How to Manage??..

21. Two approaches:
- on-balance sheet adjuste sheet adjustments
On Balance sheet Adjustments
- involve changing the portfolio of assets and liabilities in order to change
the manner in which the profitability of the bank or amount of its assets and
liabilities changes as interest rate change.
- adjusting the maturity, re-pricing and payment schedule of assets and
liabilities
APPROACHES TO MANAGE INTEREST
RATE RISK
Two approaches:
- on-balance sheet adjustments
- off-balance sheet adjustments
On Balance sheet Adjustments
- involve changing the portfolio of assets and liabilities in order to change the manner in which the
profitability of the bank or amount of its assets and liabilities changes as interest rate change.
- adjusting the maturity, re-pricing and payment schedule of assets and liabilities
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22. ASSETS AND LIABILITY MANAGEMENT
The process of making such decisions about the composition of
assets and liabilities and the risk assessment is known as
Asset/Liability Management (ALM).
The decisions are usually made by asset/liability management
committee (ALCO).

23. ASSETS AND LIABILITY MANAGEMENT
ALCO goal is to manage the sources and use of funds with respect to
interest rate and liquidity.
ALM is generally viewed as short run in nature, forcing on the day to
day and week to week balance sheet management.

24. The process of making such decisions about the composition of assets and liabilities and the risk
assessment is known as Asset/Liability Management (ALM).
The decisions are usually made by asset/liability management committee (ALCO).
HOW IT ALL STARTED..
Initially pioneered by Anglo-Saxon financial institutions during the 1970s as interest rates
became increasingly volatile
ALM was started as practice of managing risks that arise due to mismatches between
the assets and liabilities
The process is at the crossroads between risk management and strategic planning.
It is not just about offering solutions to mitigate or hedge the risks arising from the interaction
of assets and liabilities but is focused on a long-term perspective
The traditional ALM programs focus on interest rate risk and liquidity risk because they
represent the most prominent risks affecting the organization balance-sheet
Capital management was added later
It is the process of making decisions about the composition of assets and liabilities and the risk
assessment
These decisions are usually made by asset/liability management committee (ALCO). 25
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25. How to go about?
How to gear ourselves up?
Let us try
See this video
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26. ASSET LIABILITY MANAGEMENT
Various risks affecting banks / FIs
Credit, Market, Operational
Deregulation & competition
Need to manage risk to protect NIM
Need for proper risk mgt policy
Liquidity planning, interest rate risk management
ALM guidelines issued for banks in Feb 1999 and for FIs in
Dec 1999

27. CONCEPT OF ALM
ALM is concerned with strategic management of
Balance Sheet by giving due weightage to market risks
viz. Liquidity Risk, Interest Rate Risk & Currency Risk.
ALM function involves planning, directing, controlling
the flow, level, mix, cost and yield of funds of the bank
ALM builds up Assets and Liabilities of the bank based
on the concept of Net Interest Income (NII) or Net
Interest Margin (NIM).

28. WHAT IS ALM
ALM is concerned with strategic Balance Sheet management involving
all market risks
It involves in managing both sides of balance sheet to minimise
market risk

29. ALM OBJECTIVES
Liquidity Risk Management.
Interest Rate Risk Management.
Currency Risks Management.
Profit Planning and Growth Projection.

30. LIQUIDITY RISK
What is liquidity risk?
 Liquidity risk refers to the risk that the institution might not be able to
generate sufficient cash flow to meet its financial obligations
EFFECTS OF LIQUIDITY CRUNCH
Risk to bank’s earnings
Reputational risk
Contagion effect
Liquidity crisis can lead to runs on institutions
 Bank / FI failures affect economy

31. LIQUIDITY RISK
Factors affecting liquidity risk
Over extension of credit
High level of NPAs
Poor asset quality
Mismanagement
Non recognition of embedded option risk
Reliance on a few wholesale depositors
Large undrawn loan commitments
Lack of appropriate liquidity policy & contingent plan

32. LIQUIDITY RISK
Tackling the liquidity problem
 A sound liquidity policy
 Funding strategies
 Contingency funding strategies
 Liquidity planning under alternate scenarios
 Measurement of mismatches through gap statements

33. LIQUIDITY RISK
METHODOLOGIES FOR MEASUREMENT
 Liquidity index
 Peer group comparison
 Gap between sources and uses
 Maturity ladder construction

34. LIQUIDITY RISK
RBI GUIDELINES
 Structural liquidity statement
 Dynamic liquidity statement
 Board / ALCO
 ALM Information System
 ALM organisation
 ALM process (Risk Mgt process)
 Mismatch limits in the gap statement
 Assumptions / Behavioural study

35. MATURITY PROFILE-LIQUIDITY
Outflows
 Capital, Reserves & Surplus
 Deposits
 Borrowings and bonds
 Other liabilities

36. MATURITY PROFILE-LIQUIDITY
Inflows
 Cash
 Balance with RBI
 Balance with other banks
 Investments
 Advances

37. IRR - RELEVANCE IN INDIA
Deregulation of interest rates brought:
 Volatility in rates - call, PLR, Govt. securities Yield Curve
 Competition - free pricing of assets and liabilities
 Pressure on NII / NIM, MVE

38. RSA, RSL
RSA (Rate Sensitive Assets) – Assets whose value is dependent on
current interest rate
RSL (Rate Sensitive Liabilities) – Liabilities whose value is dependent
on current interest rate

39. GAP/MISMATCH RISK
It arises on account of holding rate sensitive assets and liabilities with
different principal amounts, maturity/repricing rates
Even though maturity dates are same, if there is a mismatch between
amount of assets and liabilities it causes interest rate risk and affects
NII

40. IMPACT ON NII
Gap Interest rate Change Impact on NII
Positive Increases Positive
Positive Decreases Negative
Negative Increases Negative
Negative Decreases Positive

41. ASSET-LIABILITY MANAGEMENT
COMMITTEE (ALCO)
This committee operates typically
just below the board.
In smaller banks the responsibility
is vested with the board of
management.

42. FUNCTIONS OF ALCO
Implementation of ALM System
- Monitor the risk levels of the Bank.
- Articulate the Interest Rate Position & fix interest
rate on Deposits & Advances.
- Fix differential rate of interest rate on Bulk
Deposits.
- Facilitating and coordinating to put in place the ALM
System in the Bank.

43. TOOLS FOR ALM SYSTEM
Gap Analysis
Modified Gap Analysis
Duration Gap Analysis
Value at Risk (VaR)
Simulation

44. LIQUIDITY RISKS
Broadly of three types:
Funding Risk: Due to withdrawal/non-renewal of
deposits
Time Risk: Non-receipt of inflows on account of
assets(loan installments)
Call Risk: contingent liabilities & new demand for
loans
Dynamic liquidity is done to measure the liquidity
risks

45. STATEMENT OF STRUCTURAL
LIQUIDITY
Placed 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
Banks can fix higher tolerance level for other maturity
buckets.

46. ADDRESSING TO MISMATCHES
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.

47. DYNAMIC LIQUIDITY
Prepared every fortnight for ALCO
Projection is given for the next three months
Tools for assessing the day to day liquidity needs of the bank

48. STATEMENT OF INTEREST RATE
SENSITIVITY
Generated by grouping RSA,RSL & OFF-Balance sheet items in to
various (8)time buckets.
Positive gap : Beneficial in case of rising interest rate
Negative gap: Beneficial in case of declining interest rate

49. CALCULATION OF NII/NIM
NII: INT.EARNED-INT. EXPENDED
INT. EARNED: ADV+INVEST+BALANCE WITH RBI
INT. EXPENDED:DEPOSITS+INT. ON RBI BORROWINGS
NIM= (NII/TOT.EARNING ASSET)X100

50. SUCCESS OF ALM IN BANKS :
PRE - CONDITIONS
1. Awareness for ALM in the Bank staff at all levels–supportive
Management & dedicated Teams.
2. Method of reporting data from Branches/ other Departments.
(Strong MIS).
3. Computerization - Full computerization, networking.
4. Insight into the banking operations, economic forecasting,
computerization, investment, credit.
5. Linking up ALM to future Risk Management Strategies.

51. THANK YOU
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