Æ
Æ


 


‘ Though Basel Capital Accord and subsequent RBI guidelines have given a structure for
ALM in banks, the Indian Banking system has not enforced the guidelines in total. The
banks have formed ALCO as per the guidelines; but they rarely meet to take decisions.
Public Sector banks are yet to collect 100% of ALM data because of lack of
computerization in all branches. With this background, this research aims to find out the
status of Asset Liability Management across all commercial banks in India. The
discussion paper has following objectives to explore:

r‘ To study the types of assets and liabilities in bank¶s balance sheet.

r‘ What is asset liability management and how it is implied in banks?

r‘ To study the Portfolio-Matching behavior of Indian Banks in terms of nature and

strengths of relationship between Assets and Liability.

r‘ To find out the component of Assets explaining variance in Liability and vice-versa.

r‘ To study the impact of ownership over Asset Liability management in Banks.

r‘ To study impact of ALM on the profitability of different bank-groups.




c



 Æ  

‘ People earn money to meet their day-to-day expenses on food, clothing, education of
children, housing, etc. They also need money to meet future expenses on marriage, higher
education of children, house building and other social functions. These are heavy expenses,
which can be met if some money is saved out of the present income. Saving of money is also
necessary for old age and ill health when it may not be possible for people to work and earn
their living.

‘ The necessity of saving money was felt by people even in olden days. They used to hoard
money in their homes. With this practice, savings were available for use whenever needed, but it
also involved the risk of loss by theft, robbery and other accidents. Thus, people were in need of
a place where money could be saved safely and would be available when required. Banks are
such places where people can deposit their savings with the assurance that they will be able to
withdraw money from the deposits whenever required. People who wish to borrow money for
business and other purposes can also get loans from the banks at reasonable rate of interest.

‘ Bank is a lawful organization, which accepts deposits that can be withdrawn on

demand. It also lends money to individuals and business houses that need it.

‘ Banks also render many other useful services ± like collection of bills, payment of foreign
bills, safe-keeping of jewellery and other valuable items, certifying the credit-worthiness of
business, and so on.

‘ Banks accept deposits from the general public as well as from the business community. Any one
who saves money for future can deposit his savings in a bank. Businessmen have income from
sales out of which they have to make payment for expenses. They can keep their earnings from
sales safely deposited in banks to meet their expenses from time to time. Banks give two assurances
to the depositors ±

r‘ Safety of deposit, and

r‘ Withdrawal of deposit, whenever needed

Î



 ‘ On deposits, banks give interest, which adds to the original amount of deposit. It is a great
incentive to the depositor. It promotes saving habits among the public. On the basis of deposits
banks also grant loans and advances to farmers, traders and businessmen for productive
purposes. Thereby banks contribute to the economic development of the country and well being
of the people in general. Banks also charge interest on loans. The rate of interest is generally
higher than the rate of interest allowed on deposits. Banks also charge fees for the various other
services, which they render to the business community and public in general. Interest received
on loans and fees charged for services which exceed the interest allowed on deposits are the
main sources of income for banks from which they meet their administrative expenses.

‘ The activities carried on by banks are called banking activity. µBanking¶ as an activity
involves acceptance of deposits and lending or investment of money. It facilitates business
activities by providing money and certain services that help in exchange of goods and
services. Therefore, banking is an important auxiliary to trade. It not only provides money for
the production of goods and services but also facilitates their exchange between the buyer and
seller.

‘ There are laws which regulate the banking activities in our country. Depositing money in banks
and borrowing from banks are legal transactions. Banks are also under the control of
government. Hence they enjoy the trust and confidence of people. Also banks depend a great
deal on public confidence. Without public confidence banks cannot survive









A



 ½ÆÆ  

Banks provide funds for business as well as personal needs of individuals. They play a significant
role in the economy of a nation. Let us know about the role of banking.

r‘ It encourages savings habit amongst people and thereby makes funds available for productive
use.

r‘ It acts as an intermediary between people having surplus money and those requiring money
for various business activities.

r‘ It facilitates business transactions through receipts and payments by cheques instead of

currency.

r‘ It provides loans and advances to businessmen for short term and long-term purposes.

r‘ It also facilitates import export transactions.

r‘ It helps in national development by providing credit to farmers, small-scale industries andself-

employed people as well as to large business houses which lead to balanced economic
development in the country.

r‘ It helps in raising the standard of living of people in general by providing loans for purchase
of consumer durable goods, houses, automobiles, etc







o



  Æ  

 
A bank which is entrusted with the functions of guiding and regulating the banking system of a
country is known as its Central bank. Such a bank does not deal with the general public. It acts
essentially as Government¶s banker; maintain deposit accounts of all other banks and advances money
to other banks, when needed. The Central Bank provides guidance to other banks whenever they face
any problem. It is therefore known as the banker¶s bank. The Reserve Bank of India is the central
bank of our country.
The Central Bank maintains record of Government revenue and expenditure under various heads. It also
advises the Government on monetary and credit policies and decides on the interest rates for bank
deposits and bank loans. In addition, foreign exchange rates are also determined by the central bank.
Another important function of the Central Bank is the issuance of currency notes, regulating their circulation
in the country by different methods. No other bank than the Central Bank can issue currency.

  !

Commercial Banks are banking institutions that accept deposits and grant short-term loans and
advances to their customers. In addition to giving short-term loans, commercial banks also give
medium-term and long-term loan to business enterprises. Now-a-days some of the commercial banks
are also providing housing loan on a long-term basis to individuals. There are also many other
functions of commercial banks, which are discussed later in this lesson.

"#!$ !% Commercial banks are of three types i.e., Public sector banks,
Private sector banks and Foreign banks.
(i)‘ &  !: These are banks where majority stake is held by the Government of
India or Reserve Bank of India. Examples of public sector banks are: State Bank of India,
Corporation Bank, Bank of Baroda and Dena Bank, etc. Public Sector Banks comprise
19 nationalized banks and State Bank of India and its 7 associate banks.

(ii)‘  '! !: In case of private sector banks majority of share capital of the
bank is held by private individuals. These banks are registered as companies with limited
liability. For example: The Jammu and Kashmir Bank Ltd., Bank of Rajasthan Ltd.,
Development Credit Bank Ltd, Lord Krishna Bank Ltd., Bharat Overseas Bank Ltd.,
Global Trust Bank, Vysya Bank, etc.

†



 (iii)‘  ( !: These banks are registered and have their headquarters in a foreign country
but operate their branches in our country. Some of the foreign banks operating in our
country are Hong Kong and Shanghai Banking Corporation (HSBC), Citibank, American
Express Bank, Standard & Chartered Bank, Grindlay¶s Bank, etc. The number of foreign
banks operating in our country has increased since the financial sector reforms of 1991.

'# !

Business often requires medium and long-term capital for purchase of machinery and equipment, for
using latest technology, or for expansion and modernization. Such financial assistance is provided by
Development Banks. They also undertake other development measures like subscribing to the shares
and debentures issued by companies, in case of under subscription of the issue by the public. Industrial
Finance Corporation of India (IFCI) and State Financial Corporations (SFCs) are examples of
development banks in India.

)*# ' !

People who come together to jointly serve their common interest often form a co-operative society under
the Co-operative Societies Act. When a co-operative society engages itself in banking business it is
called a Co-operative Bank. The society has to obtain a license from the Reserve Bank of India before
starting banking business. Any co-operative bank as a society is to function under the overall supervision
of the Registrar, Co-operative Societies of the State .As regards banking business, the society must
follow the guidelines set and issued by the Reserve Bank of India.

"#!$*# ' !%

There are three types of co-operative banks operating in our country. They are primary credit
societies, central co-operative banks and state co-operative banks. These banks are organized at three
levels, village or town level, district level and state level.

(i)‘  ")   !: These are formed at the village or town level with borrower
and non-borrower members residing in one locality. The operations of each society are
restricted to a small area so that the members know each other and are able to watch over
the activities of all members to prevent frauds.
(ii)‘ *# ' !: These banks operate at the district level having some of the
primary credit societies belonging to the same district as their members. These banks
provide loans to their members (i.e., primary credit societies) and function as a link between
the primary credit societies and state co-operative banks.

ù



 (iii)‘ *# ' !: These are the apex (highest level) co-operative banks in all
the states of the country. They mobilize funds and help in its proper channelization among
various sectors. The money reaches the individual borrowers from the state co-operative
banks through the central co-operative banks and the primary credit societies.

#  +) !

There are some banks, which cater to the requirements and provide overall support for setting up
business in specific areas of activity. EXIM Bank, SIDBI and NABARD are examples of such banks.
They engage themselves in some specific area or activity and thus, are called specialized banks. Let us
know about them.

,‘ -## $) ./ : If you want to set up a business for exporting
products abroad or importing products from foreign countries for sale in our country, EXIM bank can
provide you the required support and assistance. The bank grants loans to exporters and importers and
also provides information about the international market. It gives guidance about the opportunities for
export or import, the risks involved in it and the competition to be faced, etc.

,‘ )&! !'# $) . %If you want to establish a

small-scale business unit or industry, loan on easy terms can be available through SIDBI. It also finances
modernization of small-scale industrial units, use of new technology and market activities. The aim and
focus of SIDBI is to promote, finance and develop small-scale industries.

 ,  $( &&)½&'#. ½%It is a central

or apex institution for financing agricultural and rural sectors. If a person is engaged in agriculture or other
activities like handloom weaving, fishing, etc. NABARD can provide credit, both short-term and long-term,
through regional rural banks. It provides financial assistance, especially, to co-operative credit, in the field of
agriculture, small-scale industries, cottage and village industries handicrafts and allied economic activities
in rural areas.




â



 ÆÆ Æ½ 

The functions of commercial banks are of two types:

(A) Primary functions; and

(B) Secondary functions.

Let us discuss details about these functions.


.  "$& !
The primary functions of a commercial bank include:
a) Accepting deposits; and
b) Granting loans and advances.

a)‘ # ()#! !

The most important activity of a commercial bank is to mobilize deposits from the public. People who
have surplus income and savings find it convenient to deposit the amounts with banks. Depending upon
the nature of deposits, funds deposited with bank also earn interest. Thus, deposits with the bank grow
along with the interest earned. If the rate of interest is higher, public are motivated to deposit more funds
with the bank. There is also safety of funds deposited with the bank.
$!))'!
The second important function of a commercial bank is to grant loans and advances. Such loans and
advances are given to members of the public and to the business community at a higher rate of interest
than allowed by banks on various deposit accounts. The rate of interest charged on loans and advances
varies according to the purpose and period of loan and also the mode of repayment.

!
A loan is granted for a specific time period. Generally commercial banks provide short-term loans
.But term loans, i.e., loans for more than a year may also be granted. The borrower may be given the
entire amount in lump sum or in installments. Loans are generally granted against the security of
certain assets. A loan is normally repaid in installments. However, it may also be repaid in lump sum.

)'!
An advance is a credit facility provided by the bank to its customers. It differs from loan in the sense that
loans may be granted for longer period, but advances are normally granted for a short period of time.
Further the purpose of granting advances is to meet the day-to-day requirements of business. The rate of

U



interest charged on advances varies from bank to bank. Interest is charged only on the amount
withdrawn and not on the sanctioned amount.

"#!$)'!
Banks grant short-term financial assistance by way of cash credit, overdraft and bill discounting.

!0) 
Cash credit is an arrangement whereby the bank allows the borrower to draw amount up to a specified
limit. The amount is credited to the account of the customer. The customer can withdraw this amount
as and when he requires. Interest is charged on the amount actually withdrawn. Cash Credit is granted
as per terms and conditions agreed with the customers.

Æ')$
Overdraft is also a credit facility granted by bank .A customer who has a current account with the bank
is allowed to withdraw more than the amount of credit balance in his account. It is a temporary
arrangement. Overdraft facility with a specified limit may be allowed either on the security of assets, or
on personal security, or both.

 !& ($ !

Banks provide short-term finance by discounting bills, i.e. making payment of the amount before the due
date of the bills after deducting a certain rate of discount. The party gets the funds without waiting for the
date of maturity of the bills. In case any bill is dishonored on the due date; the bank can recover the
amount from the customer.

)"$& !
In addition to the primary functions of accepting deposits and lending money, banks perform a
number of other functions, which are called secondary functions. These are as follows-

a.‘ Issuing letters of credit, travelers cheque, etc.

b. Undertaking safe custody of valuables, important document and securities by providing

safe deposit vaults or lockers.

c.‘ Providing customers with facilities of foreign exchange dealings.

Ë



 d.‘ Transferring money from one account to another; and from one branch to another
branch of the bank through cheque, pay order, demand draft.

e.‘ Standing guarantee on behalf of its customers, for making payment for purchase of
goods, machinery, vehicles etc.

f.‘ Collecting and supplying business information.

g.‘ Providing reports on the credit worthiness of customers.

h.‘ Providing consumer finance for individuals by way of loans on easy terms for purchase
of consumer durables like televisions, refrigerators, etc.

i.‘ Educational loans to students at reasonable rate of interest for higher studies, especially
for professional courses

* (.   (

With advancement in information and communication technology, banking services are also made available
through computer. Now, in most of the branches you see computers being used to record banking
transactions. Information about the balance in your deposit account can be known through computers. In
most banks now a days human or manual teller counter is being replaced by the Automated Teller Machine
(ATM). Banking activity carried on through computers and other electronic means of communication is
called µelectronic banking¶ or µe-banking¶. Let us now discuss about some of these modern trends in
banking in India.

‡ &)0 
Banks have now installed their own Automated Teller Machine (ATM) throughout the country at
convenient locations. By using this, customers can deposit or withdraw money from their own account
any time.

c



‡  )
Banks are now providing Debit Cards to their customers having saving or current account in the
banks. The customers can use this card for purchasing goods and services at different places in lieu of
cash. The amount paid through debit card is automatically debited (deducted) from the customers¶
account.

‡ ) )
Credit cards are issued by the bank to persons who may or may not have an account in the bank. Just
like debit cards, credit cards are used to make payments for purchase, so that the individual does not
have to carry cash. Banks allow certain credit period to the credit cardholder to make payment of the
credit amount. Interest is charged if a cardholder is not able to pay back the credit extended to him
within a stipulated period. This interest rate is generally quite high.

‡   (
With the extensive use of computer and Internet, banks have now started transactions over Internet.
The customer having an account in the bank can log into the bank¶s website and access his bank
account. He can make payments for bills, give instructions for money transfers, fixed deposits and
collection of bill, etc.

‡ 0  (
In case of phone banking, a customer of the bank having an account can get information of his account,
make banking transactions like, fixed deposits, money transfers, demand draft, collection and payment of
bills, etc. by using telephone.
As more and more people are now using mobile phones, phone banking is possible through mobile
phones. In mobile phone a customer can receive and send messages (SMS) from and to the bank in
addition to all the functions possible through phone banking.






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 ½ 

‘ Risk and its management has assumed greater significance in recent years due to
changing risk perception in banks. Risk has been present always in the banking business
but the discussion on managing the same has gained prominence only lately.

‘ Bankers world-wide have come to realize that the growing deregulation of local markets
and their gradual integration with global markets have deepened their anxieties. With
growing sophistication in banking operations, while lending and deposits ± taking have
continued to remain the mainstay of a majority of commercial banks, many have
branched into derivatives trading, securities underwriting and corporate advisory
businesses.

‘ Some banks have even expanded their traditional credit product lines to include asset
securitization and credit derivatives. Still other have greatly increased their transaction
processing, custodial services or asset management businesses in the pursuit of increased
fee income. As a consequence, the issue of risk management has gained new recognition
in recent times.

‘ With improvements in information technology, more and more banks will possibly
venture into the relative new world of on-line electronic banking covering apart from
traditional banking, providing of bill presentation and payment services. This would
mean an increase in the diversity and complexity of risks. Banks would have to develop
risk management systems that are rigorous and comprehensive, yet flexible enough to
address newer risks they assume.




ƽ½

Four risks confront banks viz., credit risk, interest rate risk, foreign exchange risk and liquidity
risk.

A.‘ CREDIT RISK

r‘ The credit risk remains the predominant risk for most banks, despite changes in
banking over the last few years. Even in normal times, credit risk attracts
considerable attention of credit planners and is extremely important.

co



 r‘ The credit risk depends on both internal and external factors. The external factors
are the state of the economy, swings in commodity prices and equity prices,
foreign exchange rates interest rates, etc.

r‘ The internal factors are deficiencies in loan policies and administration of loan
portfolio which would cover weaknesses in the area of prudential credit
concentration limits, appraisal of borrowers¶ financial position, excessive
dependence on collateral and inadequate risk pricing, absence of loan review
mechanism and post sanction surveillance etc. Such risks may extend beyond the
conventional credit products such as loans and letters of credit and appear in more
complicated, less conventional forms, such as credit derivatives or tranches of
securitized assets or outstanding commitments.

B.‘ INTEREST RATE RISK

r‘ The second category risk that has gained prominence is interest rate risk. Interest
rate risk arises because banks fix and refix interest rates on their resources and on
the assets on which they are deployed at different times.

r‘ Changes in interest rates can significantly impact the interest income, depending
on assets and liabilities are reset. Any such mismatch in cash flows (fixed asset or
liabilities) or reprising dates (floating assets or liabilities) expose bank¶s net
interest margin to variations.

C.‘ FOREIGN EXCHANGE RISK

r‘ Third important category of risk pertains to foreign exchange risk. The risk
inherent in running open foreign exchange positions has become pronounced in
recent years owing to the wide variation in exchange rates.

r‘ Such risks arise owing to adverse exchange rate movements, which may affect a
banks open position, either spot or forward, or a combination of the two, in any
individual foreign currency.

c†



 D.‘ LIQUIDITY RISK

r‘ The final major category of financial risk is liquidity risk. The liquidity risk arises
from funding of long-term assets by short-term liabilities or resources, thereby
making the liabilities subject to rollover or refinancing risk.

r‘ Those banks that fund their domestic assets with foreign currency deposits with
them may be particularly susceptible to liquidity risk when sharp fluctuations in
exchange rates and market turbulence make it difficult to retain sources of
financing.

‘ Beyond the four basic financial risks, banks have a host of other concerns. Some of them,
like operating risk, are due to natural outgrowth of their business. Banks employ standard
risk avoidance techniques to mitigate them. In other cases, for instance, where counter-
party risk is seen as significant, it is evaluated using standard credit risk procedures.

‘ Likewise, most bankers would view legal risks as arising from their credit decisions or,
more likely, from absence of proper procedure while finalizing a financial contract. It
does not require very sophisticated tools to cover such risk.

‘ In managing credit risk, the key issue is to recognize the need to apply a consistent
evaluation and rating scheme of all investment opportunities. This is essential in order
for credit decisions to be made in a consistent manner.

‘ Prudential limits need to be laid down on various aspects of credit, viz., benchmark
current debt/equity and profitability ratios, debt service coverage ratios, concentration
limits for single/group borrower, maximum exposure limits to industry etc. There should
be provision of some flexibility to allow for very special features.

‘ A comprehensive risk scoring system needs to be developed that serves as a single point
indicator of diverse risk factors of counter-party.

‘ As for managing interest rate risk, most banks make a clear distinction between their
trading activity and their balance sheet exposure. As regards trading book, Value-at-Risk
(VaR) is presently the standard approach. The Var method is employed to access the
potential loss that could crystallize on portfolio due to variations in market interest rate

cù



 and prices. For balance sheet exposure to interest rate risk, banks rely on µgap reporting
system¶; identify asymmetry in reprising of assets and liabilities commonly known as gap
and putting in place a gap reporting system. This is often supplemented with balance
sheet simulation models to investigate the effect of interest rate variation on reported
earnings over a medium-time horizon.

‘ Coming to foreign exchange risk, limits are key elements of risk management in foreign
exchange trading, as they are for all trading business. As a general characterization, banks
with active trading positions have tended to adopt the VaR approach to measure the risk
associated with exposure. For banks that could not develop VaR, some stress testing is
required to be conducted to evaluate the potential loss associated with changes in
exchange rate. This is done for small movements in the exchange rates, as well as for
historical maximum movements.

‘ The final point is the measurement of liquidity risk. There are several traditional ratios
for liquidity risk measurements, viz ; loans to total assets, loans to core deposits, ratio of
large liabilities to earning asset and loan losses to net loans. In addition, prudential limits
are placed on various measures like inter-bank borrowings and core deposits vis-à-vis
core assets.

‘ Several points need to be tackled as regarding positioning appropriate risk management

strategies. There is an increasing trend towards centralising risk management with
integrates treasury management to benefit from information synergies on aggregate
exposure, as well as scale economies and easier reporting to top management.

‘ The primary responsibility of understanding the risks run by the bank and ensuring that
such risks are appropriately addressed should be vested with the Board of Directors. At
organisational level, overall risk management needs to be vested with an independent
Risk Management Committee or Executive Committee of top executives entrusted with
the responsibility of identifying, measuring and monitoring the risk profile of the bank
that reports directly to the directly to the Board Of Directors.

‘ The committee should develop policies and procedures, verify the models used for
pricing complex products and identify newer risks impacting bank¶s balance sheet.
Finally, adherence to risk parameters of the various operating departments of the bank
should also be overseen by the committee.

câ



 ‘ Observers are by now unanimous in their view that developing sound and healthy
financial institutions, especially banks, is a sine qua non for maintaining overall stability
of the financial system.

‘ Keeping this in view, the Reserve Bank has issued broad guidelines for risk management
systems in banks. This has placed the primary responsibility of laying down risk
parameters and establishing the risk management and control system on the Board of
Directors of the bank.

‘ However, the implementation of the integrated risk management could be assigned to a

risk management committee or alternately, a committee of top executives that reports to
the board. The risk management guidelines also require banks to constitute a high level
credit policy committee to deal with issues pertaining to credit sanction, disbursement
and follow-up procedures and to manage and control credit risk for the bank as a whole.

‘ The Reserve Bank advised banks to set up a credit risk management department to
enforce and monitor compliance of the risk parameters and prudential limits set by the
Board or credit policy committee. The set of guidelines issued by RBI is purposed to
serve as a benchmark to the banks, which are yet to establish an integrated risk
management system.

‘ However, it is to be recognized that, in view of diversity and varying size of balance

sheet items as between banks, it might neither be possible nor necessary to adopt a
uniform risk management system.

‘ The design of risk management framework should, therefore, be oriented towards the
bank¶s own requirement dictated by the size and complexity of business, risk philosophy,
market perception and the existing level of capital. While doing so, banks may critically
evaluate their existing risk management system in the light of the guidelines issued by the
Reserve Bank and should identify the gaps in the existing risk management practices and
the policies and strategies for complying with the guidelines.

‘ In addition to the risk management guidelines, the levels of transparency and standards of
disclosure have gradually been enhanced over the years so as to provide a clearer picture
of balance sheet to informed readers.

cU



 ‘ Accordingly, from the year ended March 31, 2000, an enhanced set of disclosures are
required to be disclosed by banks as µNote to Accounts¶ to their balance sheet. Such
disclosures and transparency practices are aimed at improving the process of expectation
formation by market players about behavior and eventually lead to effective decision-
making in banks.

‘ In addition, RBI has laid down credit concentrations norms, both for individual borrowers
as well as to a group as a whole.

%

1.‘ First, risk management is closely related to ALM. Any mismatch between assets and
liabilities increases risks, whether it is interest rate risk, credit risk or liquidity risk.
Accurate risk identification and classification of past losses into expected and unexpected
losses would help in positioning comprehensive internal controls. Not a simple
proposition, it requires in depth study and analysis of financial and other markets.

2.‘ Secondly, the evaluation of credit rating continues to be an imprecise process. Overtime
one should expect that the banks rating procedures should be compatible with rating
systems elsewhere in the capital market and have the same degree of objectivity.

3.‘ A third area where improvements seem warranted is the analysis of ex-post outcomes
from lending. Credit losses are, currently not preciously related to credit rating. They
need to be more closely tracked by the banks than they currently are. In short, credit
pricing, credit rating and expected losses ought to be demonstrably linked.

4.‘ Fourthly, interest rate risk approaches include both the trading systems; there has been a
considerable improvement. The VaR methodology has converted a rather subjective
hand-on process of risk control to more quantitative one.

5.‘ Finally, as banks move more towards off-balance sheet activities must be better
integrated into overall risk management and strategic decision making. Currently, they
are ignored when bank risk management is considered or are at a fairly primitive stage. If
reasonable exposure estimates are to be obtained, much more need to be done including
building up of a strong Management Information System (MIS) backed up by a sound
database.

cË



 7½ÆÆ

 

Economic Factors 

 
 



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  ÆÆ 

‘ ALM is defined as, ³the process of decision ± making to control risks of existence,
stability and growth of a system through the dynamic balances of its assets and
liabilities.´

‘ The text book definition of ALM is ³a risk management technique designed to earn an
adequate return while maintaining a comfortable surplus of assets beyond liabilities. It
takes into consideration interest rates, earning power and degree of willingness to take on
debt. It is also called surplus- management´.


6
?

‡‘ An attempt to match:
‘‘‘‘‘‘‘‘‘‘‘‘‘‘‘‘‘‘‘‘‘‘‘‘‘‘‘‘‘‘‘‘‘‘‘‘‘‘‘‘‘‘‘‘
  



‡‘ In terms of:
 




 


‡‘ To minimize:



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Ά



 ‘ Asset Liability Management (ALM) defines management of all assets and liabilities (both
off and on balance sheet items) of a bank. It requires assessment of various types of risks
and altering the asset liability portfolio to manage risk.

‘ Till the early 1990s, the RBI did the real banking business and commercial banks were
mere executors of what RBI decided. But now, BIS is standardizing the practices of
banks across the globe and India is part of this process.

‘ The success of ALM, Risk Management and Basel Accord introduced by BIS depends on
the efficiency of the management of assets and liabilities. Hence these days without
proper management of assets and liabilities, the survival is at stake.

‘ A bank¶s liabilities include deposits, borrowings and capital. On the other side of the
balance sheets are assets which are loans of various types which banks make to the
customer for various purposes. To view the two sides of banks¶ balance sheet as
completely integrated units has an intuitive appeal. But the nature, profitability and risk
of constituents of both sides should be similar.

‘ The structure of bank¶s balance sheet has direct implications on profitability of banks
especially in terms of Net Interest Margin (NIM). So it is absolute necessary to maintain
compatible asset-liability structure to maintain liquidity, improve profitability and
manage risk under acceptable limits.




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‘ Risk is inherent in banking and is unavoidable. Asset Liability Management is not to

avoid but to manage risks (mismatch) at the same time sustaining the profitability. This
requires periodic monitoring of risk exposures which involves arrangements for
collecting and analyzing information. It involves ability to anticipate, forecasts and to act
so as to structure the bank¶s business to profit from it.

‘ Asset liability management seek to contain risk while pursuing profit at the same time.
The risks are not independent from each other. They are in practice inter-linked and
hence do not offer specific solution easily. Therefore, techniques do not give solutions
straight away. Asset management like all management depends ultimately on judgment
and decision making.

‘ Asset liability management is concerning with all aspects of business involving financial
decisions. Thus there is a considerable technicalities to make policy, to ensure consistent
implementation and to monitor the results.

‘ Generally large banks constituted a committee with representatives drawn from all main
functions of the bank, called Asset Liability Committee (ALCO) for the management.
This committee operates typically just below the board. In smaller banks the
responsibilities is vested with the board of management.

‘ ALM involves both long term and short term policy decisions. While the long term
policies need to be approved by the highest level, the short term policy needs delegation
of both responsibility and authority. There is a need to develop accounting and
supervisory system to ensure smoother implementations of ALM function.

‘ Decisions would also involve the geographical dispersal of dealing markets, the dealing
parties and dealing offices/personnel. Also the institutionalizing of ALM requires certain
investments in training, information and communication system, developing new types of
business products, etc.

‘ To conclude, the doctrine of return versus risk suggests that no institution should avoid
taking risk. However, the question of scales, dimension and magnitude of risk as well as
return to be defined, in implemented and monitored. The ALM techniques provide a
framework for same in effective manner.

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‘ There are several reasons for the growing importance of ALM function. More important
are the exposures of the institution directly and indirectly to the risk situations and the
need to safeguard the position proactively. The following recent trend also necessitates
the ALM function in banks.

i.‘ Financial volatility

ii.‘ Explosion of new financial products
iii.‘ Regulatory initiatives
iv.‘ Heightened awareness of top management

i.‘ Financial Volatility

During the past decade we have witnessed heightened volatility in the financial
market in India and rest of the world. Increased volatility results in greater
uncertainties in profitability, portfolio value and solvency. When there is a risk, there
is a need for risk management, which is effective. ALM has become critical in the
volatile financial environment of the recent past. The financial volatility is examined
in detail under interest rate risk discussed separately.

ii.‘ New Financial Product Innovation

The second reason for growing importance of ALM is the explosive growth of new
financial products. These products are innovated by the market players in India and
abroad and the agencies like RBI, FIMMDA, SEBI, etc; also introduced several new
products during the last decade. While analyzing new products, we need to
understand:

^‘ Product mechanics
^‘ Pricing
^‘ Applications
^‘ Potential risks

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 iii.‘ Regulatory Initiatives

The regulatory agencies throughout the world have taken several measures to enhance
sophistication and regulation of ALM. The Basel Committee on bank supervision
issued an amendment in January 1996, to the Capital Accord 1988, to incorporate
Market Risk in the supervisory norms. The supervisory authorities were asked to
implement the same by year-end 1997.

Accordingly, RBI issued guidelines in February 1999; the ALM system was to cover
at least 60% of the assets and liabilities of the banks effective from 1 April 1999 and
100% from 1 April 2000.

iv.‘ Management Recognition

The high profile head-line making derivatives disasters, losses related to market risks,
the affect of interest rate movements on the income of banks, have enhanced the level
of awareness of top management. They have begun to take greater interest, ask more
questions and want to improve the oversight of the risk management system in banks.






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‘ The objective of ALM is ³Exposure by choice, not by chance´ i.e. ³Risk by choice and
not by chance´, ³Clean bet and not confused bet´, ³bet with your head, not over our
head´.

‘ Thus the objective of ALM is not to eliminate risk but to manage it. In this endeavour
risk and reward go together.

‘ Setting and articulating risk management objective is the first logical step in establishing
professional ALM function. Without clear objective, it is not possible to decide whether a
particular decision or transaction is right or wrong.

‘ Also, a particular transaction cannot be measured in isolation, but in the context of its
contribution to the accomplishment of the overall objectives.

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In order to have effective ALM function, it is necessary to put in place all necessary elements. A
piecemeal approach may be in effective and inappropriate. The nine essential elements of an
ALM function are:

a.‘ (  8 - A proactive product planning and pricing tool

b.‘ Æ( +  8 - Clearly defined roles and responsibilities of ALCO

c.‘ "  8 ± Use of analytical tools like gap, duration, simulation, etc.

d.‘ 0(" 8 ± Automation and software selection and performance

e.‘ Æ#  8 - Well documented & approved ALM procedure manual

f.‘ $!& 8 - Asset based financial spread or liability

based financial spread or profit through market based transformation.

g.‘ $ ½# ( 8 - For clear, useful, timely information.

h.‘ ½(&"#  8 - To comply with various requirements

i.‘  8 ± Checks & balances for integrity of data, analysis, reporting, etc.

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‘ Asset liability management can be done in three different ways:

i.‘ Æ* !0: Business strategies involving product mix and pricing of loan,
deposits and other borrowings.

ii.‘ Æ* !0: Investment strategies involving maturity mix and rate
characteristics of investment securities.

iii.‘ Æ$$* !0% Use of derivatives to manage Asset-liability risks

‘ Off balance sheet strategies like swap transactions is relatively fast as compared to on-
balance sheet strategy of accomplishing desired product mix/pricing changes takes time
and effort.

‘ The hedging process is easy and fast where as frequent product mix/pricing may cause
confusion to customers.

‘ The cost of off-balance sheet strategy and on-balance sheet strategy need to be
considered as both involve costs.

‘ One should not rush to use derivatives simply because they are available. Effective Asset
Liability Management does not necessarily require derivatives.

‘ Even in the markets, where the derivatives are ALM is critical and necessary as a risk
management tool.

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As per RBI guidelines, commercial banks are to distribute the outflows/inflows in
different residual maturity period known as time buckets. The Assets and Liabilities
were earlier 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 are
outflows while the asset figures are inflows. In September, 2007, having regard to the
international practices, the level of sophistication of banks in India, 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 revised these guidelines and it
was provided that

(a) 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., next day , 2-7 days and 8-14 days. 0&!A88
0'1= &!, After such an exercise, each bucket of assets is matched with the
corresponding bucket of the liability. When in a particular maturity bucket, the amount
of maturing liabilities or assets does not match, such position is called a mismatch
position, which creates liquidity surplus or liquidity crunch position and depending upon
the interest rate movement, such situation may turn out to be risky for the bank. Banks
are required to monitor such mismatches and take appropriate steps so that bank is not
exposed to risks due to the interest rate movements during that period.

(b) The net cumulative negative mismatches during the Next day, 2-7 days, 8-14 days and
15-28 days buckets should not exceed 5 %, 10%, 15 % and 20 % of the cumulative cash
outflows in the respective time buckets in order to recognize the cumulative impact on
liquidity.

The Board¶s of the Banks have been entrusted with the overall responsibility for the
management of risks and is required to decide the risk management policy and set limits
for liquidity, interest rate, foreign exchange and equity price risks.

Asset-Liability Committee (ALCO) is the top most committee to oversee the

implementation of ALM system and it is to be headed by CMD or ED. ALCO considers
product pricing for 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.

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