asset liability managment

8/12/2019 Asset Liability Managment

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INTRODUCTION OF ASSET-LIABILITY MANAGEMENT

In banking,asset and liability management

is the practice of managing

risksthat arise due to mismatches between the assets and liabilities (debts and

assets) of the bank. This can also be seen in insurance.

Banks face several risks such as the liquidity risk, interest rate risk, credit

riskand operational risk. sset !iability management (!") is a strategic

managementtool to manage interest rate risk and liquidity risk faced bybanks,

other financial services companies and corporations.

Banks manage the risks of sset liability mismatchby matching the assets

and liabilitiesaccording to the maturity pattern or the matching the duration, by

hedging and by securiti#ation. "uch of the techniques for hedgingstem from the

delta hedgingconcepts introduced in the Black$%cholesmodel and in the work of

&obert '. "ertonand &obert . arrow.

!iquidity management is a provoking idea for the management of the

financial institutions to ponder about and act. But how to act and when to act are

the questions which lead to ssets and !iability "anagement (!"), a

management tool to monitor and manage various aspects of risks associated with

the balance sheet management, including the management and balance sheet

eposure of the institutions. In other words, *!" is an ongoing process of

formulating, monitoring, revising and framing strategies related to assets and

liabilities in an attempt to achieve the financial ob+ective of maimi#ing interest

spread or margins for a given set of risk level. It is not only a liquidity

management tool, but also a portfolio management tool to alter the composition of

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http://en.wikipedia.org/wiki/Riskhttp://en.wikipedia.org/wiki/Liquidity_riskhttp://en.wikipedia.org/wiki/Interest_rate_riskhttp://en.wikipedia.org/wiki/Credit_riskhttp://en.wikipedia.org/wiki/Credit_riskhttp://en.wikipedia.org/wiki/Operational_riskhttp://en.wikipedia.org/wiki/Strategic_managementhttp://en.wikipedia.org/wiki/Strategic_managementhttp://en.wikipedia.org/wiki/Bankhttp://en.wikipedia.org/wiki/Corporationhttp://en.wikipedia.org/wiki/Asset_liability_mismatchhttp://en.wikipedia.org/wiki/Assethttp://en.wikipedia.org/wiki/Liabilitieshttp://en.wikipedia.org/wiki/Securitizationhttp://en.wikipedia.org/wiki/Hedge_(finance)http://en.wikipedia.org/wiki/Delta_hedginghttp://en.wikipedia.org/wiki/Black-Scholeshttp://en.wikipedia.org/wiki/Robert_C._Mertonhttp://en.wikipedia.org/wiki/Robert_A._Jarrowhttp://en.wikipedia.org/wiki/Riskhttp://en.wikipedia.org/wiki/Liquidity_riskhttp://en.wikipedia.org/wiki/Interest_rate_riskhttp://en.wikipedia.org/wiki/Credit_riskhttp://en.wikipedia.org/wiki/Credit_riskhttp://en.wikipedia.org/wiki/Operational_riskhttp://en.wikipedia.org/wiki/Strategic_managementhttp://en.wikipedia.org/wiki/Strategic_managementhttp://en.wikipedia.org/wiki/Bankhttp://en.wikipedia.org/wiki/Corporationhttp://en.wikipedia.org/wiki/Asset_liability_mismatchhttp://en.wikipedia.org/wiki/Assethttp://en.wikipedia.org/wiki/Liabilitieshttp://en.wikipedia.org/wiki/Securitizationhttp://en.wikipedia.org/wiki/Hedge_(finance)http://en.wikipedia.org/wiki/Delta_hedginghttp://en.wikipedia.org/wiki/Black-Scholeshttp://en.wikipedia.org/wiki/Robert_C._Mertonhttp://en.wikipedia.org/wiki/Robert_A._Jarrow


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assets and liability portfolio to manage the risk by using various risk mitigating

measures.

ssets-liability management is an integral part of the planning process of

commercial banks. In fact, asset-liability management may be considered as one of

the three principal components of a planning system. The t!eecomponents are

$$ sset-liability management which focuses primarily on the day$to$day or

week$to$week balance sheet management necessary to achieve short term financial

goals.

$$ nnual profit planning and controls which focus on slightly longer term

goals and look at a detailed financial plan over the course of a fiscal or calendar

year.

$$ %trategic planning which focuses on the long run financial and non

financial aspects of a bank/s performance.

DEFINITION OF ASSET-LIABILITY MANAGEMENT

*If there is any area of banking that has undergone drastic change, it is the whole

sub+ect of assets-liabilities management.

- "a#l S$ Nadle!

*%trong capital will not guarantee liquidity in all circumstances. There can be

panics and sudden increase in the demand for liquidity. It is the +ob of the central

banks to help in those circumstances. But a strong capital base in the system and inall its components is likely to limit future liquidity shocks.

- %ean "ie!!e Landa#&

De'#ty G()e!n(!& Ban* (+ F!an,e

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CONCE"T OF ALM

!" is a system of matching cash inflows and outflows in the system, and

is thus a management tool of liquidity management. 0ence, if a bank meets its

'ash &eserve &atio ('&&) and %tatutory !iquidity &atio (%!&) stipulation

regularly without undue and frequent resort to purchased - borrowed funds and

without defaults, it can be said to have a satisfactory system of managing liquidity

risks and so, of !". The spread between the deposit and lending rates were wide

and also were more or less uniform and changed only at the instance of the &BI.

'learly, the institutions, themselves were not managing the balance sheet1 it was

being 2managed/ and controlled through prescriptions of the regulatory authority

and the government. 3ver since the initiation of the process of deregulation and

liberation of interest rates and consequent in+ection of a dose of competition, the

need for !" was felt. 4ith deregulation of interest rates and greater freedom

being given to the organi#ations to decide and mange the cost of lending and

borrowing and ultimately management of the balance sheet. 0ence, the need for a

system such as !", which could provide the necessary framework to define,measure, monitor, modify and manage the interest risk.

sset-liability management focuses on the net interest income if the

institutions. 5et interest income is the difference between the amount of interest

received from loans and investments and the amount of interest paid for deposits

and other liabilities.

Net inte!est in,(me inte!est !e)en#e . inte!est e/'ense

3pressing the net interest income as a percentage of earning allows us to

epress the interest income as a margin. The total net interest income may not be

meaningfully compared between banks of different si#e but the margin may be

meaningfully compared.

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Net inte!est ma!gin Net inte!est in,(me 0 ea!ning assets

E1OLUTION OF ASEET- LIABILITY IN BAN2S

3ver since the initiation of the process of deregulation of the Indian

banking system and gradual freeing of interest rates to market forces, and

consequent in+ection of a dose of competition among the banks, introduction of

asset$liability management (!") in the public sector banks (6%Bs) has been

suggested by several eperts. But, initiatives in this respect on the part of most

bank managements have been absent. This seems to have led the &eserve Bank of

India to announce in its monetary and credit policy of 7ctober 899: that it would

issue !" guidelines to banks. 4hile the guidelines are awaited, an informal

check with several 6%Bs shows that none of these banks has moved decisively to

date to introduce !".

7ne reason for this neglect appears to be a wrong notion among bankers

that their banks already practice !". s per this understanding, !" is a system

of matching cash inflows and outflows, and thus of liquidity management. 0ence,

if a bank meets its cash reserve ratio and statutory liquidity ratio stipulations

regularly without undue and frequent resort to purchased funds, it can be said to

have a satisfactory system of managing liquidity risks, and, hence, of !".

The actual concept of !" is however much wider, and of greater

importance to banks; performance. 0istorically, !" has evolved from the early

practice of managing liquidity on the bank;s asset side, to a later shift to the

liability side, termed liability management, to a still later realisation of using both

the assets as well as liabilities sides of the balance sheet to achieve optimum

resources management. But that was till the 89:


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interest rates in >% and 3urope caused the focus to broaden to include the issue

of interest rate risk. !" began to etend beyond the bank treasury to cover the

loan and deposit functions. The induction of credit risk into the issue of

determining adequacy of bank capital further enlarged the scope of !" in later

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monetary and credit policy of 7ctober 899: recommends, an adequate system of

!" to incorporate comprehensive risk management should be introduced in the

6%Bs. It is suggested that the 6%Bs should introduce !" which would focus on

liquidity management, interest rate risk management and spread management.

Broadly, there are @ requirements to implement !" in these banks, in the stated

order 3a4developing a better understanding of !" concepts, 3b4 introducing an

!" information system, and, 3,4setting up !" decision$making processes

(!" 'ommittee-!'7). The above requirements are already met by the new

private sector banks, for eample. These banks have their balance sheets available

at the close of every day. &epeated changes in interest rates by them during the last

@ months to manage interest rate risk and their maturity mismatches are based on

data provided by their "I%. In contrast, loan and deposit pricing by 6%Bs is based

partly on hunches, partly on estimates of internal macro data, and partly on their

competitors; rates. 0ence, 6%Bs would first and foremost need to focus son putting

in place an !" which would provide the necessary framework to define,

measure, monitor, modify and manage interest rate risk. This is the need of the

hour.

5ISTORICAL "ERS"ECTI1E

The !", historically, has evolved from the early practice of managing

liquidity on the bank/s asset side, to a later shift to the liability side and termed

liability management, to a still later reali#ation of using both the assets as well as

the liabilities side of the balance sheet to achieve optimum resources management,

i.e., an integrated approach. 6rior to deregulation, bank funds were obtained from

relatively stable demand deposits and from small time deposits. Interest rate ceiling

limited the etent to which banks could compete for funds. 7pening more branches

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in order to attract fresh deposits. s a result, most sources of funds were core

deposits which were quite impervious to interest rate movements in this

environment bank fund management concentrate on the control of assets. The

bank/s ability to grow will be hampered if they do not have access to the funds

required to create assets. They have freedom to obtain funds by borrowing from

both the domestic and international markets. s they tap different source of funds,

there is an increased need for liability management and it becomes an important

part of their financial management.

4ith liability management, banks now have two sources of funds A core

deposits and purchased funds A with quite different characteristics. or core

deposits, the volume of funds is relatively insensitive to changes in interest rate

levels. rom the perspective of the management, the core deposits offer the

advantage of stability. 0owever core deposits have the disadvantage of not being

overly responsive to management needs for epansion. If a bank eperiences a

si#eable increase in loan demand, it can not epect the core deposits to increase

proportionately. or purchased funds, however, the bank can obtain all the funds

that it wants if it is willing to pay the market determined price. >nlike core

deposits where the bank determines the price, the interest rates on purchased funds

are set in the national money market. The bank can be thought of as a price taker in

the purchased funds market whereas in the core deposit market it can be viewed as

a price setter. The purchased funds give complete fleibility in terms of the

volumes and timing of the availability of funds.

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MODERN "ERS"ECTI1E

The recent volatility of interest rates broadened to include the issue of

credit risk and market risk and to ensure that their risk management capabilities are

commensurate with the risk of their business. The induction of credit risk into the

issue of determining adequacy of bank capital further enlarged the scope of !".

ccording to policy approach of Basel II in India, to conform to best international

standards and in the process emphasis is on harmoni#ation with the international

best practices. If this were so, the scope and the role of !" becomes all the more

enlarged. Incidentally, commercial banks in India will start implementing Basel II

with effect from "arch @8, C


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CLASSIFICATION OF ASSETS AND LIABILITIES

ASSETS CLASSIFICATION LIABILITIE

S

ANDCA"ITAL

CLASSIFICATION

Dault cash 5&% Eemand

Eeposits

5&%!

%hort term

securities

&% 'urrent

account

5&%!

!ong term

securities

5%& "oney market

deposits

&%!

Dariable rateloans

&% %hort termdeposits

&%!

%hort term

loans

&% !ong term

savings

5&%!

long term

loans

5&% &epo

transactions

&%!

7ther assets 5&% equity 5&%

The above table shows the classification of the assets and liabilities of a

bank according to their interest rate sensitivity. Those assets and liabilities whose

interest return or costs vary with interest rate changes over some time hori#on are

referred to as &ate %ensitive ssets(&%) or &ate %ensitive !iabilities(&%!).

Those assets or liabilities whose interest return or costs do not vary with interest

rate movements over the same time hori#on are referred to as 5on A rate %ensitive

ssets (5&%) or 5on A rate %ensitive !iabilities (5&%!). It is very important to

note that the critical factor in the classification is the time hori#on chosen. n asset

or liability that is time sensitive in a certain time hori#on may not be sensitive in a

shorter time hori#on and vice A versa. 0owever, over a sufficiently long time

hori#on, virtually all assets and liabilities are interest rate sensitive. s the time

hori#on is shortened, the ratio of rate sensitive to non rate sensitive assets and

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liabilities falls. t some sufficiently short hori#on, say one day, virtually all assets

and liabilities are non interest rate sensitive.

ALM STRATEGY

s interest rated in both the liability and the asset side were deregulated,

interest rates in various market segments such as call money, 'E/s and the retail

deposit rates turned out to be variable over a period of time due to competition and

the need to keep the bank interest rates in alignment with market rates.

'onsequently the need to adopt a comprehensive sset$ liability strategy emerged,

the key ob+ectives of which were as under.

The volume, mi and cost-return of both liabilities and assets need to be

planned and monitored in order to achieve the bank/s short and long term goals.

"anagement control would comprehensively embrace all the business

segments like deposits, borrowing, credit, investments, and foreign echange. It

should be coordinated and internally consistent so that the spread between the

bank/s earnings from assets and the costs of issuing liabilities can be

maimi#ed.

%uitable pricing mechanism covering all products like credit, payments,

custodial financial advisory services should be put in place to cover all costs

and risks.

The principal purpose of asset - liability management has been to control the

si#e of the net interest income. The control may be defensive or aggressive. The

goal of defensive asset-liability management is to insulate the net interest

income from changes in interest rates. In contrast, aggressive asset-liability

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management focuses on increasing the net interest income by altering the

portfolio of the institution.

Both defensive and aggressive asset - liability management relate to the

management of the interest rate sensitivity position of the asset and liability

portfolio of the bank, and the success or failure of the strategies depend upon

the effects of interest rates. or the success of the aggressive asset - liability

management, it is necessary to forecast future interest rate changes. 7n the

other hand, defensive strategy does not require the forecast of future interest

rate changes. The attempt is to isolate the bank from either an increase or

decrease in the rates.

ASSET MANAGEMENT STRATEGY

%ome banks had the traditional deposit base and were also capable of

achieving substantial growth rates in deposits by active deposit mobili#ation drive

using their etensive branch network. or such banks the ma+or concern was how

to epand the assets securely and profitably. 'redit was thus the ma+or key

decision area and the investment activity was based on maintaining a statutory

liquidity ratio or as a function of liquidity management. The management strategy

in such banks was thus more biased towards asset management.

LIABILITY MANAGEMENT STRATEGY

%ome banks on the other hand were unable to achieve retail deposit

growth rates since they did not have a wide branch network. But these banks

possessed superior asset management skills and hence could fund assets by relying

on the wholesale markets using 'all money, 'E/s Bill &ediscounting etc.

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Eeregulation of interest rates coupled with reforms in the money market

introduced by the reserve bank provided these banks with the opportunity to

compete with funds from the wholesale market using the pricing strategy to

achieve the desired volume, mi and cost. %o under the !iability management

approach, banks primarily sought to achieve maturities and volumes of funds by

fleibly changing their bid rates for funds.

STRATEGIC A""ROAC5ES TO ALM

Spread Management

This focuses on maintaining an adequate spread between

a bank/s interest epense on liabilities and its interest income on assets.

Gap Management This focuses on identifying and matching rate sensitive

assets and liabilities to achieve maimum profits over the course of interest rate

cycles.

Interest Sensitivity Analysis This focuses on improving interest spread by

testing the effects of possible changes in the rates, volume, and mi of assets

and liabilities, given alternative movements in interest rates.

These strategies attempt to closely co$ordinate bank assets and liability

management so that bank/s earnings are less vulnerable to changes in interest rates.

4e will now look at each of these strategies in a more detailed fashion.

S"READ MANAGEMENT

This focuses on maintaining an adequate spread between a bank/s interest

rate eposure on liabilities and its interest rate income on assets to ensure an

acceptable profit margin regardless of interest rate fluctuations. Thus spread

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management aims to reduce the bank/s eposure to cyclical rates and to stabili#e

earnings over the long term and in order to achieve these banks must manage the

maturity, rate structure and risks in its portfolios so that assets and liabilities are

more or less affected equally by interest rate cycles.

"aturities on assets and liabilities are either matched or unmatched. If they

are matched then the bank knows what it must pay for deposits and borrowed

funds and what it will earn on loans and investments. If maturities are unmatched

then assets and liabilities will mature at different times and in this case

management cannot lock in a spread because funds must be reinvested as assets

mature and funds must be borrowed as liabilities mature at rates that may differ

from current market rates.

'o$coordinating rate structure among assets and liabilities is a second most

important aspect of spread management because rate structure and maturity

combined determine interest sensitivity in assets and liabilities. or rate structure,

the rates paid and earned on fied$ rate assets and liabilities are not sensitive to

changes in market rates because their rates are fied for the term of theinstrument/s maturity. Dariable rate assets and liabilities are interest sensitive

because their earnings fluctuate with changing market conditions.

&isk of default is the third aspect of assets and liabilities that must be

coordinated in spread management. bank assumes greater risk of default in its

asset portfolios than it can in its liability portfolios since the depositor/s funds need

to be protected. Therefore balancing the default risk against the benefit of probable

returns by assuming some risk to maintain a profitable spread is vital.

Because it is difficult to forecast future rate and yield changes accurately,

many banks try to match their rate sensitive assets to their rate sensitive liabilities.

This approach will lead to controlled but steady growth and a gradual increase in

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average profitability.

GA" MANAGEMENT

Fap management is based on the following rate mi classifications

1a!iable6 Interest bearing assets and liabilities whose rates fluctuates with

general money market conditions.

Fi/ed6Interest bearing assets and liabilities with a relatively fied rate over an

etended period of time.

Mat,ed6 %pecific sources and uses of funds in equal amounts that have

predetermined maturities.

By definition, gap is the amount by which the rate sensitive assets

eceed the rate sensitive liabilities. The gap indicates the dollar amount of funds

available to fund the variable rate assets with variable rate liabilities. Fap

measurement allows the management to evaluate the impact the various interest

rate changed will have on earnings.

The ob+ective of gap management is to identify fund imbalances. or

eample, If rates are declining and the banks have an ecess of variable rate assts

over fied rate liabilities the bank/s rate will narrow and interest rate margin will

be reduced. 7n the other hand if rates are increasing and variable rate assets eceed

fied rate liabilities the bank/s rate will widen and interest margin will increase.

The gap is really a measurement of the bank/s balance sheet sensitivity to

changes in the interest rates ,epressed as a ratio of the rate sensitive assets to ratesensitive liabilities. The greatest stability occurs when rate sensitive assets equal

rate sensitive liabilities or a ratio of 8.

The matched gap in the fig illustrates this position. In general, with this

ratio the bank/s earnings should remain the same regardless of the interest rate

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changes because equal amount of assets and liabilities will be repriced.

Then the sensitivity ratio is greater than 8, the bank has a positive gap, or

is asset sensitive. This position is illustrated by the second gap in ehibit. If interest

rates rise, the bank will benefit as more assets than liabilities are repriced at higher

rates. 'onversely, if rates fall the bank/s margin will be negatively affected as

more assets than liabilities will be repriced at lower rates.

INTEREST SENSITI1ITY ANALYSIS

This is an etension of gap management. It attempts to improve the interestspread by testing the effects of changes in rates, volume, and mi of assets and

liabilities given alternative movements in interest rates. In this analysis, the bank

plans from a given point in time and pro+ects possible changes in its income

statement that might result if changes are made in the balance sheet. %uch changes

are then tested against scenarios of rising rates and falling rates for periods ranging

from two weeks to one year.

The analysis begins by separating the bank/s balance sheet into fied rate

and variable rate components. The interest rate and margin are identified in the

current year. The net step lists the various assumptions that involve the rate, mi,

and volume of the bank/s portfolios$ for eample, pro+ected increases in the

volume of loans, consumer time deposits, and larger 'E/s, as well the current rates

on these instruments. The remaining key assumptions reflect the possible

alternative directions in which the rates may move. The bank then tests the effect

of assumed changes in the volume and composition of its portfolios against both

interest rate scenarios (rising and falling rates) to determine their impact on interest

spread and margin.

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0owever if the bank/s assets and liabilities are unmatched, the bank/s

earnings can be protected or improved by planning courses of action in advance for

periods of rising and falling rates.

0edging with futures trading is a final strategy that can be used to protect

against eposure to interest rate risk if the bank/s interest sensitive assets and

liabilities are unmatched. Banks can use futures contracts as tools of !" by

selling futures ( a short hedge) or buying futures (a long hedge). If the bank is in an

unmatched position in which the interest sensitive assets are funded by fied rate

liabilities, it makes a long hedge. If the position is one of fied rate assets funded

by interest sensitive liabilities the bank makes a short hedge. The ability to use

hedging effectively to offset risk in an unmatched position require that the future

course of interest rate levels be predicted accurately.

MEASURING INTEREST RATE SENSITI1ITY

The most commonly used measure of the interest rate position of a bank

is Fap analysis. The Fap is the difference between the amount of the rate sensitive

assets and rate sensitive liabilities. The Fap may be epressed in a variety of ways.

The simplest is the rupee Fap A the difference between the amounts of &% and

&%! epressed in rupees. %ome other measures of Fap are the relative Fap ratio,

which is the ratio of the rupee Fap and the Total assets. nother measure is the

interest rate sensitivity ratio, which is the ratio of the &% to &%!.

Relati)e Ga' !ati( R#'ee Ga' 0 T(tal assets

Inte!est !ate sensiti)ity !ati( RSA 0 RSL

bank at a given time may be asset or liability sensitive. If the bank were

asset sensitive, it would have a positive Fap, appositive relative Fap ratio and an

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interest sensitivity ratio greater than one. 'onversely, a bank that is liability

sensitive would have a negative Fap, a negative relative Fap ratio and interest

sensitivity ratio less than one. Banks that are asset sensitive eperience an increase

in their net interest income when interest rate increase and vice A versa.

'onversely, banks that are liability sensitive see their net interest income decrease

when interest rate and vice A versa. The below table summaries the effects interest

rate changes on net interest income for different Fap positions.

EFFECTS OF C5ANGES IN INTEREST RATES

GA" Canges in Inte!est Rate Canges in Net Inte!est

Rate

6ositive Increase Increase

6ositive Eecrease Eecrease

5egative Increase Eecrease

5egative Eecrease Increase

Gero Increase Gero

Gero Eecrease Gero

The focus of asset-liability management is on interest rate risk. 0owever, a

management is concerned with managing the entire risk profile of the institutions,

including interest risk, credit risk, liquidity risk and other dimensions of risk. If

those risks were unrelated, then managers could concentrate on one type of risk,

making appropriate decisions and ignoring the effect of the decisions on the other

types of risks. 0owever, the different types of risks have a high degree of

correlation, especially the interest rate risk and the credit risk.

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ASSET-LIABILITY MANAGEMENT "ROCESS

The !" process rests on three pillars

ALM in+(!mati(n systems

$ "anagement Information %ystem

$ Information availability, accuracy, adequacy and epediency

ALM (!ganisati(n

$ %tructure and responsibilities

$ !evel of top management involvement

ALM '!(,ess

$ &isk parameters

$ &isk identification

$ &isk measurement

$ &isk management

$ &isk policies and tolerance level

ALM in+(!mati(n systems

Information is the key to the !" process. 'onsidering the large network of

branches and the lack of an adequate system to collect information required for

!" which analyses information on the basis of residual maturity and behavioural

pattern it will take time for banks in the present state to get the requisite

information. The problem of !" needs to be addressed by following an B'

approach i.e. analysing the behaviour of asset and liability products in the top

branches accounting for significant business and then making rational assumptions

about the way in which assets and liabilities would behave in other branches. In

respect of foreign echange, investment portfolio and money market operations, in

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view of the centralised nature of the functions, it would be much easier to collect

reliable information. The data and assumptions can then be refined over time as the

bank management gain eperience of conducting business within an !"

framework. The spread of computerisation will also help banks in accessing data.

ALM ORGANI7ATION

8at D(esAsset-Liability Committee - ALCOMean9

risk$management committee in a bank or other lending institution that generally

comprises the senior$management levels of the institution. The !'7;s primary

goal is to evaluate, monitor and approve practices relating to risk due to

imbalances in the capital structure.

Asset-Liability Committee - ALCO

or eample, the !'7 will have responsibility for setting limits on the arbitrage

of borrowing in the short$term markets, while lending long$term

instruments. mong the factors considered are liquidity risk, interest rate risk,

operational risk and eternal events that may affect the bank;s forecast and

strategic balance$sheet allocations. The !'7 will generally report to the board of

directors and will also have regulatory reporting responsibilities.

) The Board should have overall responsibility for management of risks and

should decide the risk management policy of the bank and set limits for liquidity,

interest rate, foreign echange and equity price risks.

B) The sset $ !iability 'ommittee (!'7) consisting of the bank;s senior

management including '37 should be responsible for ensuring adherence to the

limits set by the Board as well as for deciding the business strategy of the bank (on

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the assets and liabilities sides) in line with the bank;s budget and decided risk

management ob+ectives.

') The !" desk consisting of operating staff should be responsible for

analysing, monitoring and reporting the risk profiles to the !'7. The staff should

also prepare forecasts (simulations) showing the effects of various possible

changes in market conditions related to the balance sheet and recommend the

action needed to adhere to bank;s internal limits.

The !'7 is a decision making unit responsible for balance sheet planning

from risk $ return perspective including the strategic management of interest rate

and liquidity risks. 3ach bank will have to decide on the role of its !'7, its

responsibility as also the decisions to be taken by it. The business and risk

management strategy of the bank should ensure that the bank operates within the

limits - parameters set by the Board. The business issues that an !'7 would

consider, interalia, will include product pricing for both deposits and advances,

desired maturity profile of the incremental assets and liabilities, etc. In addition to

monitoring the risk levels of the bank, the !'7 should review the results of and

progress in implementation of the decisions made in the previous meetings. The

!'7 would also articulate the current interest rate view of the bank and base its

decisions for future business strategy on this view. In respect of the funding policy,

for instance, its responsibility would be to decide on source and mi of liabilities or

sale of assets. Towards this end, it will have to develop a view on future direction

of interest rate movements and decide on a funding mi between fied v-s floating

rate funds, wholesale v-s retail deposits, money market v-s capital market funding,

domestic v-s foreign currency funding, etc. Individual banks will have to decide

the frequency for holding their !'7 meetings.

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C(m'(siti(n (+ ALCO

The si#e (number of members) of !'7 would depend on the si#e of each

institution, business mi and organisational compleity. To ensure commitment of

the Top "anagement, the '37-'"E or 3E should head the 'ommittee. The

'hiefs of Investment, 'redit, unds "anagement - Treasury (fore and domestic),

International Banking and 3conomic &esearch can be members of the 'ommittee.

In addition the 0ead of the Information Technology Eivision should also be an

invitee for building up of "I% and related computerisation. %ome banks may even

have sub$committees.

C(mmittee (+ Di!e,t(!s

Banks should also constitute a professional "anagerial and %upervisory

'ommittee consisting of three to four directors which will oversee the

implementation of the system and review its functioning periodically.

FUNDAMENTAL STE"S OF AN ALM "ROCESS

n effective !" process begins with the support of the entity/s senior

management. 7ngoing communication is essential. The process consists of five

fundamental steps

:$ ASSESS T5E ENTITY;S RIS20RE8ARD OB%ECTI1ES

The purpose of !" is not necessarily to eliminate or even minimi#e risk.

The level of risk will vary with the return requirement and entity/s ob+ectives.

inancial ob+ectives and risk tolerances are generally determined by senior

management of an entity and are reviewed from time to time.

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UANTIFY T5E LE1EL OF RIS2 E?"OSURE

&isk eposure can be quantified

8) relative to changes in the component pieces,

C) as a maimum epected loss for a given confidence interval in a given set ofscenarios, or

@) by the distribution of outcomes for a given set of simulated scenarios for the

component piece over time. &egular measurement and monitoring of the risk

eposure is required.

@$FORMULATE AND IM"LEMENT STRATEGIES TO MODIFY

E?ISTING RIS2S

!" strategies comprise both pure risk mitigation and optimi#ation of

the risk-reward tradeoff. &isk mitigation can be accomplished by modifying

eisting risks through techniques such as diversification, hedging, and portfolio

rebalancing. or a given risk tolerance level, a given set of investment

opportunities, and a given set of constraints, optimi#ation ensures that the portfolio

has the most desirable risk-reward tradeoff. 7ptimi#ation presupposes that the

management team has been previously educated on the risk-reward profile of the

business and understands the necessity to take action based on !" analysis.

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6ractitioners are cautioned not to put undue reliance on the results of a mechanical

calculation. 6rofessional +udgment is an important part of the process.

$ MONITOR RIS2 E?"OSURES AND RE1ISE ALM STRATEGIES AS

A""RO"RIATE

!" is a continual process. ll identified risk eposures are monitored

and reported to senior management on a regular basis. If a risk eposure eceeds

its approved limit, corrective actions are taken to reduce the risk eposure. or

pension plans, monitoring current financial status and possible short$term

outcomes is very helpful in managing pension risk.

7perating within a dynamic environment, as the entity/s risk tolerances and

financial ob+ectives change, the eisting !" strategies may no longer be

appropriate. 0ence, these strategies need to be periodically reviewed and modified.

formal, documented communication process is particularly important in this

step.

"RINCI"LES OF ASSET-LIABILITY MANAGEMENT

. ECONOMIC 1ALUE

!" focuses on 3conomic Dalue. consistent !" structure can

only be achieved for economic ob+ectives. 3conomic value is based on future

asset and liability cash flows. !" uses these future cash flows to determine the

risk eposure and achieve the financial ob+ectives of an entity.

n entity/s financial ob+ectives may include maimi#ing one or more

of these values economic value, accounting measures such as earnings and return

on equity, or embedded value. or private pension plans, financial ob+ectives may

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include the pattern of future funding requirements. Darious accounting measures

are affected by rules that change the emergence of income and the reported book

value of the assets and liabilities. These measures can sometimes distort

economic reality and produce results inconsistent with economic value. Because

!" is concerned with the future asset and liability cash flows, the natural focus

of !" is economic value. ccounting measures or future funding requirements

are often included as constraints within an !" framework.

3ntities that focus on economic value tend to achieve their financial

ob+ectives more consistently in the long term.

B$ MUTUAL DE"ENDENCE

!iabilities and their associated assets are mutually dependent.

"utual dependence arises in an !" contet because of the necessity to

manage the interdependence between the asset and liability cash flows to achieve

economic and financial ob+ectives. The mutual dependence principle applies to

portfolios consisting of both assets and liabilities. It holds even if the assets and

liabilities are affected by different economic factors, or even if asset and liability

cash flows are fied.

"utual dependence may be greater when the performance of one portfolio

affects the performance of another portfolio. or eample, the credited rate on the

liabilities may influence the lapse-withdrawal rate, which in turn may requireunepected liquidation or reinvestment of assets.

The mutual dependence principle implies that assets and liabilities must

be managed concurrently in order to optimi#e achievement of economic and

financial ob+ectives.

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C$ DI1ERSIFICATION

The level of risk associated with a given financial ob+ective can be

reduced through diversification by combining eposures that are less than 8


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accepted, greater reward commensurate with higher risk levels may not be actually

reali#ed.

In an !" contet, the riskiness of a portfolio is determined by the net

position of the combined assets and liabilities.

E$CONSTRAINTS

3pected risk-reward trade$off tends to worsen as more constraints are

imposed and as the constraints become more restrictive.

n !" framework contains internal and eternal constraints including

investment policy requirements, rating agency epectations, regulatory issues, andrequired capital goals. or eample, an investment policy may specify that no

below investment grade bonds may be purchased and bonds downgraded to below

investment grade must be sold within @< days. This constraint forces a sale at a

time when a bond/s price is under short$term pressure and may offer an

opportunity to investors not sub+ect to this constraint.

nother common eample of constraints within an !" contet is the

professional +udgment constraints applied to outcomes generated by mathematical

models. or eample, traditional efficient frontier analysis is etremely sensitive to

input assumptions, and slight ad+ustments to assumptions can produce very

different efficient portfolio outcomes. 6rofessional +udgment is typically applied to

temper the model/s outcomes by constraining asset class allocations and forcing

additional portfolio diversification.

F$DYNAMIC EN1IRONMENT

The risks to which an entity is eposed and the associated rewards are

determined by internal and eternal factors that change over time.

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!" is an ongoing process. &isks an entity assumes and to which it is

eposed are continuously changing. Internal factors arise from the financial

ob+ectives, risk tolerances, and constraints of the entity. 3ternal factors include

interest rates, equity returns, competition, the legal environment, regulatory

requirements, and ta constraints. %uch factors often impact both assets and

liabilities simultaneously, although the impact is not necessarily of the same

magnitude or in the same direction. urthermore, an entity may have different risk

tolerances under different circumstances and for different time hori#ons.

ccordingly, analyses, conclusions, and strategies relevant to a specific point in

time need to be periodically reevaluated and updated.

G$UNCERTAINTY

sset and liability cash flows cannot be pro+ected with certainty.

The dynamic environment as well as pure randomness create uncertainties in the

portfolio cash flows and, hence, in the true risk eposure. &isks varies as the

underlying risk factors (e.g., interest rates, equity returns, defaults,

policyholder-customer behavior, lapses-withdrawals, pension shutdowns, etc.)

change and as future epected cash flows are replaced by actual cash flows. This

process reflects cash flows reacting to factor changes (e.g., interest$sensitive cash

flows), truing up to actual eperience, and results in revisions of future

assumptions. The ultimate risk eposure will be a function of the actual cash flows.

!" requires the use of models to pro+ect future uncertain cash flows. In

some cases, simple deterministic models can be used and !" can be based on

one set of epected future cash flows. In other cases, such as when future cash

flows are epected to depend on future economic conditions, more comple

models may be required to understand the interaction of the asset and liability cash

flows.

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%tochastic models are often used to simulate future epected cash flows

under various scenarios to help identify the associated risk eposures. These

models produce statistical distributions of potential results and different !"

strategies can be evaluated by studying the range of results produced from

modeling these strategies. "odeling can also be used to construct many possible

futures or scenarios, and then, results across all the scenarios can be used to

measure risk in the portfolio.

"odel risk is the additional risk created when the model does not

adequately represent the underlying process or reality. There are two general

classes of model risk the risk of model misspecification, oversimplification, or

outright errors, and the risk of a changing environment not anticipated in the

model. or eample, using a lognormal model of stock market prices produces a

distribution with too few etreme value sample points (i.e., that is not *fat enough

in the tails) to adequately assess the risk for some comple embedded options, such

as guaranteed minimum death benefits. In addition, the volatility of equity returns

varies over time and this may not be accurately captured in the model.

5$ 5EDGING

The overall risk of a portfolio may be reduced through hedging.

0edging plays an integral role in the !" process. 7nce the risks associated with

a portfolio or transaction has been identified, the eisting risks can be modified to

suit the entity/s risk tolerances and financial ob+ectives. >ndertaking additional

risks that partially or fully offset the eisting risks may accomplish this goal.

0edging may be done at either the transaction or portfolio level. 0edging

may be complete or partial, perfect or imperfect (i.e., cross hedging). 0edging

instruments include assets, liabilities, and derivatives. n asset with a matching

liability is a natural hedge. The time hori#on over which the hedge is in place may

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vary, but should nevertheless be eplicitly defined.

&isk can be controlled through diversification when the law of large

numbers applies (e.g., when risks are diversifiable). 0edging is a strategy available

to reduce risk when the law of large numbers does not operate, such as when a

stock market decline results in equity$linked guarantees of an annuity block of

business being in the money for every annuity contract at the same time.

0edging may reduce some risks but often introduces other risks, such as

counterparty risk and basis risk. Basis risk arises from imperfect or partial hedging,

where the hedging instruments are not perfectly negatively correlated with the risks

being hedged. In some instances, an imperfect hedge may even increase the overall

risk.

s the overall risk is reduced through hedging, the epected reward

normally decreases as well.

A""LICABILITY OF ALM "RINCI"LES

wide variety of entities are faced with !" related considerations. %uch

entities include

Insurance companies, banks and thrifts, investment firms, and

other financial services

companies

6ension and trust funds (e.g., endowments and foundations)

Fovernments

7ther commercial or not$for$profit enterprises

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Individual investors

ASSET-LIABILITY MANAGEMENT IN RIS2 FRAME8OR2

Asset$!iability "anagement (!") can be termed as a 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 and hence is also known as

%urplus "anagement.

But in the last decade the meaning of !" has evolved. It is now used in

many different ways under different contets. !", which was actually pioneered

by financial institutions and banks, are now widely being used in industries too.

The %ociety of ctuaries Task orce on !" 6rinciples, 'anada, offers the

following definition for !" sset !iability "anagement is the on$going

process of formulating, implementing, monitoring, and revising strategies related

to assets and liabilities in an attempt to achieve financial ob+ectives for a given set

of risk tolerances and constraints.

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CREDIT RIS2 MANAGEMENT

'redit risk management plays a vital role in the way banks perform. It

reflects

$ The profitability

$ !iquidity

$ &educed 56s.

'redit risk management is a process that puts in place systems and

procedures enabling a bank to$

$ Identify J measure the risk involved in a credit proposition, both at

the individual transaction and portfolio level.

$ 3valuate the impact of eposure on bank/s financial statements.

$ ssess the capability of risk mitigates to hedge- insure risks.

$ Eesign an appropriate risk management strategy to arrest *risk$

migration.

8ay +(! C!edit Ris* Management6-

'redit risk management is done at two levels$"icro level J "acro level.s

the credit risk management at micro$level is focused on clients, the efficiency level

of the operating staff in credit evaluation and monitoring needs to be honed up.

In macro level approach to credit risk management, the 'apital dequacy

&atio ('&) plays a crucial role. The bank management stipulates the industry

eposures keeping the overall position of its credit deployment.

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&isk transfer is a popular risk management technique being used today. The

development of credit derivatives is a logical etension of two of the most

significant developments such as securiti#ation and derivatives. credit asset is a

bundle of risks and returns. nd every asset is acquired to make certain returns.

0owever, the probability of not making the epected return is the default risk

associated with every credit asset. 7ne of the alternatives available to a bank in

managing credit risk is the use of credit derivatives. 'redit derivatives facilitate

risk transfer. This concept has picked up momentum in the >% and 3uropean

markets and is yet to pick up in India. 'onsidering the pathetic scenario of loan

portfolio in Indian banks, our regulators can eplore the possibilities of developing

instruments facilitating credit risk transfer.

LI>UIDITY RIS2 MANAGEMENT

"easuring and managing liquidity needs are vital activities of commercial

banks. By assuring a bank;s ability to meet its liabilities as they become due,

liquidity management can reduce the probability of an adverse situation

developing. The importance of liquidity transcends individual institutions, as

liquidity shortfall in one institution can have repercussions (indirect effect) on the

entire system. Bank management should measure not only the liquidity positions of

banks on an ongoing basis but also eamine how liquidity requirements are likely

to evolve under crisis scenarios. 3perience shows that assets commonly

considered as liquid like Fovernment securities and other money market

instruments could also become illiquid when the market and players are

unidirectional. Therefore liquidity has to be tracked through maturity or cash flow

mismatches. or measuring and managing net funding requirements, the use of a

maturity ladder and calculation of cumulative surplus or deficit of funds at selected

maturity dates is adopted as a standard tool.

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The "aturity 6rofile could be used for measuring the future cash flows of

banks in different time buckets. The time buckets given the %tatutory &eserve

cycle of 8K days may be distributed as under

i) 8 to 8K days

ii) 8L to C= days

iii) C9 days and upto @ months

iv) 7ver @ months and upto M months

v) 7ver M months and upto 8C months

vi) 7ver 8 year and upto C years

vii) 7ver C years and upto L years

viii) 7ver L years

Best "!a,ti,es +(! Managing Li#idity Ris*

&ecent volatility in the wholesale funding markets has served to highlight the

importance of sound liquidity risk management practices and reinforce the lesson

that those banks with well$ developed risk management functions are better

positioned to respond to new funding challenges. The banking industry has

developed many innovative solutions in response to these challenges, some of

which are presented here. Because banks vary widely in their funding needs, the

composition of their funding, the competitive environment in which they operate,

and their appetite for risk, there is no one set of universally applicable methods for

managing liquidity risk. 4hile there is little commonality in their approach to

liquidity risk management, well$managed banks utili#e a common si$step process

to manage it.

Meas#!ement Systems

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"ost banking eperts agree that maintaining an appropriate system of metrics

is the linchpin upon which the liquidity risk management framework rests. If they

are to successfully manage their liquidity position, management needs a set of

metrics with position limits and benchmarks to quickly ascertain the bank/s true

liquidity position, ascertain trends as they develop, and provide the basis for

pro+ecting possible funding scenarios rapidly and accurately. In addition, the bank

should establish appropriate benchmarks and limits for each liquidity measure. The

varied funding needs of institutions preclude the use of one universal set of

metrics. s a result, banks frequently use a combination of stock and flow liquidity

measures or have gone to eclusive reliance on models. %tock measures look at the

dollar levels of either assets or liabilities on the balance sheet to determine whether

or not these levels are adequate to meet pro+ected needs. low measures use cash

inflows and outflows to determine a net cash position and any resultant surplus or

deficit levels of funding. "odels are built utili#ing hypothetical scenarios to

develop measures, benchmarks, and limits.

Balance$sheet$based measures are generally best suited to smaller institutionswhich fund their business lines, generally loans, with core deposits. These banks

generally develop their measurement system and their corresponding benchmarks

and limits based on either selected peer group analysis or on studies of historical

liquidity needs over time. In addition, most of these banks utili#e flow measures to

determine their net cash position. 4hile this combination works well for smaller

banks, regional and global institutions that have significant trading operations and

are heavily reliant on purchased funding find that stock and flow measures are no

longer adequate to meet their needs. s a result, these banks have either developed

or have purchased model$based measurement systems to assist them in liquidity

measurement.

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Im'lementati(n

There is some diversity within the industry on how to implement the

contingency plan. %ome banking organi#ations have developed predefined triggers

that automatically implement the plan, while others rely on a set of critical warning

signals that require senior management to review the situation and decide whether

to implement it. To assist banks in developing their liquidity crisis warning signal

criteria, the following list of the most common early warning signs is offered

NTraditional funds providers start to disappear.

NIndividual deal si#es begin to decrease as funders become more

conservative.

NThere are difficulties accessing longer$term money (particularly over

quarter$end reporting dates).N

It becomes more difficult to manage rising funding costs in a stable market.

N'ustomers start to cash in 'Es and other time deposit products prior to

maturity.

The bank begins to be closed out of some markets and is increasingly being

forced to relyNon brokers.

'ounterparty resistance develops to bank off$balance sheet products.

6olicy and strategy considerations. unding policies and strategies should be in

place to deal with various issues in a consistent manner during a liquidity crisis.

%ome of these issues include

Bank and affiliate funding and off$balance sheet product strategies.

NIdentification of sensitive markets to avoid.

N3stablishment of formal pricing policies.

N6ayout of deposit products prior to maturity.

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Eirect vs. broker-dealer funding methods.

N"anagement of secondary market trading-discount of bank and holding

company liabilityNinstruments.

CURRENCY RIS2 MANAGEMENT

loating echange rate arrangement has brought in its wake pronounced

volatility adding a new dimension to the risk profile of banks; balance sheets. The

increased capital flows across free economies following deregulation have

contributed to increase in the volume of transactions. !arge cross border flows

together with the volatility has rendered the banks; balance sheets vulnerable to

echange rate movements

Eealing in different currencies brings opportunities as also risks. If the

liabilities in one currency eceed the level of assets in the same currency, then the

currency mismatch can add value or erode value depending upon the currency

movements. The simplest way to avoid currency risk is to ensure that mismatches,

if any, are reduced to #ero or near #ero. Banks undertake operations in foreign

echange like accepting deposits, making loans and advances and quoting prices

for foreign echange transactions. Irrespective of the strategies adopted, it may not

be possible to eliminate currency mismatches altogether. Besides, some of the

institutions may take proprietary trading positions as a conscious business strategy.

"anaging 'urrency &isk is one more dimension of sset$ !iability

"anagement. 6resently, the banks are also free to set gap limits with &BI;s

approval but are required to adopt Dalue at &isk (Da&) approach to measure the

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risk associated with forward eposures. Thus the open position limits together with

the gap limits form the risk management approach to fore operations.

USING FUTURES& O"TIONS AND S8A"S

%ome relatively new techniques that can be used by banks to manage their

asset$liability portfolio include future, option and swaps. lthough these

instruments have come into vogue in the last two decades in the >% and 3urope,

they have eperienced a tremendous growth and are becoming very significant in

asset$liability management. lthough these techniques are used primarily in

defensive asset$liability management, they can also be used in aggressive

management.

The ad+ustments to the bank/s portfolio involve changing the current cash or

spot market positions in the portfolio of assets and liabilities. 3quivalent

ad+ustment in the bank/s interest sensitive positions can be achieved through

transactions in the future markets. future contract is a standardi#ed agreement to

buy or sell a specified quantity of a financial instrument on a specified future date

at a set price. These future transactions in effect create synthetic positions with

interest sensitivity positions different from those currently held in the portfolio.

7ne of the other ma+or techniques used to manage interest rate risk is the

interest rate swap. In an interest rate swap, two firms that want to change their

interest rate eposure in different directions get together (usually through an

intermediary) and echange (swap) their obligation to pay interest. 7nly the

interest is swapped and not the principal. 'ompared to futures, swaps have both

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advantages and disadvantages. irst swaps may be customi#ed to meet the needs of

the banks. %econdly, swaps can be arranged for longer terms (say @ to 8< years)

whereas futures contracts are usually of shorter duration (usually under M months).

%waps also have disadvantage compared to future contract. s swaps are

customi#ed contracts, it involves time (and epense) in getting the right swap

transactions. %econd due to the customi#ation, it is difficult to correctly evaluate a

swap and close out a contract, compared to futures. 3qually significantly, the bank

that enters into a swap agreement faces the risk of counterparty default.

LIABILITY MANAGEMENT

In the broadest sense liability management involves the planning and co$

ordination of all the bank/s sources of funds in order to maintain liquidity,

profitability and safety to maintain long$term growth. 3ffective liability

management ensures that funds are available over the short term to meet reserve

requirements and to provide adequate liquidity, and over the long term to satisfy

loan demand and to provide investment earnings. The basic concerns of liability

management are how a bank can best influence the volume, cost and stability of

the various types of funds it can obtain.

Objectives

4hen a bank needs funds to cover deposit withdrawals or ton epand its

loans to acquire other assets, it can obtain the needed funds in two ways. 7ne way

of acquiring funds is to liquidate some of the short term assets that the bank holds

in units liquidity account for this purpose. bank can also obtain funds by

acquiring additional liabilities i.e. by buying the funds it needs. Basically, liability

management seeks to control the sources of funds that a bank can obtain quickly

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and in large amounts, unlike demand and savings deposits, which cannot be

increased to any great degree over a short time period. Eepending on cost and

availability, a bank will use a variety of liability management instruments to obtain

the liquidity needed for daily cash management, for loan epansion, and for other

earnings opportunities.

!iability management provides a bank with an alternative to asset liquidation

to obtain needed funds, and the bank chooses between these alternatives based on

the relative costs and risks involved. or eample depending on a bank/s si#e and

on market conditions, a bank in need of liquidity may chose to borrow government

funds or issue 'E/s rather than sell Treasury bills or other liquid assets. !iability

management also provides a bank with an alternative to asset management in

obtaining the greatest value from inflows of funds. Therefore a bank which follows

both assets and liability management strategies has the option of using cash

inflows to obtain more short term liquid assets or to repay outstanding liabilities,

depending on which option provides the best combination of earnings and safety.

BENEFITS OF LIABILITY MANAGEMENT

The key benefit of using !iability "anagement as a funding strategy is that

it provides a bank with an alternative to asset management for short term

ad+ustments of funds. or eample ssume that the bank eperiences a sudden

and unepected marked decline in the level of its demand deposits. If the bank/s

only source of liquidity is its assets, it must sell some of its securities to obtain the

funds needed to cover the run off of its deposits, whether or not market conditions

are favorable. 4ith liability management, the bank may be able to raise the needed

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funds by incurring liabilities, thereby postponing the sale of its assets until

conditions are more favorable.

!iability management also provides a bank with the means of funding long

term growth. It does so by enabling a bank to epand its loans ad other assets by

managing its liabilities so that a certain volume of its liabilities remains

outstanding at all times so that it can build up on its deposit levels and thereby

epand the level of its loans. This approach of funding is normally followed within

a contet of a long term upswing in the economy in which the borrowers seek more

loans for business epansion and depositors place their funds in negotiable timecertificates to earn competitive rates. In such cases, bank management must have a

clear idea of the level of outstanding liabilities that it can count on holding through

tight money periods by offering competitive rates.

nother benefit of liability management is that it allows banks to invest

greater percentage of its available funds in its securities that provide less liquidity

but offer higher earnings, this is possible because the bank/s liquidity account does

not have to bear the full burden of the bank/s liquidity needs. bank that has the

option of obtaining liquidity through its liabilities has an opportunity to increase

profitability because it can reduce the amount of short term assets it holds for

liquidity purposes and place those funds into longer term securities that offer less

liquidity but offer higher earnings.

RIS2S IN1OL1ED IN LIABILITY MANAGEMENT

lthough the use of liability management along with asset management

allows a bank the least costly method of obtaining liquidity from a wider range of

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funding options, but the added options that liability management provides also

require greater compleity in planning and eecuting funds management strategies.

This is so since banks can obtain money market deposits and liabilities only by

paying market rates and the behavior of financial markets cannot be predicted with

complete accuracy.

nother risk involved is that of issuing long term fied rate 'E/s at the peak

of the business cycle. This results in more costly 'E/s in the future with a fall in

the interest rates. In fact if short term assets are funded by long term liabilities and

rates subsequently decline, a bank may find that it is paying more for funds than it

can earn on those funds. nother risk that relates to the changing market conditions is the stability of

the bank/s sources of borrowed or purchased funds. 4hile large money center

banks are usually able to obtain funds under tight money conditions if they are

willing to pay market rates, smaller banks may find it impossible to compete for

funds when prices are high. The risk that a funding house may prove unreliable is

also a real problem for smaller banks that move outside their trading areas or that

undertake funding by means of liability instruments with which they are not

completely familiar. %uch banks face the very real possibility that their sources of

funds may disappear +ust when they are most needed.

GA" MANAGEMENT

The basic benefits of liability management lie in the options it provides a

bank in obtaining a least costly method of funding given the bank/s particular

needs and the eisting conditions of the financial markets. The risk involved in

liability management basically results from too much reliance on the use of

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purchased funds without recogni#ing the impact that changing market conditions

or other unanticipated changes can have on the bank/s ability to secure funds when

the money is scarce.

In a Fap management strategy, the aim is to reduce the volatility of the net

interest income. >nlike the aggressive strategy, there is no attempt to profit from

the anticipated change in rates. The defensive strategy attempts to keep the volume

of rate sensitive assets in balance with that of rate sensitive liabilities over a given

period. If successful, an increase in the interest rates will produce equal increases

in interest revenue and interest epense, with the result that net interest income and

net interest margin will not change.

It is important to note that a defensive strategy is not necessarily a passive

strategy. 'ontinuous ad+ustments to the assets and liability portfolio are necessary

to maintain #ero Fap. or eample, suppose a variable rate loan was paid off. If the

Fap were #ero prior to the pay$off, it would be negative afterwards and

ad+ustments will have to be made. In order to restore the #ero Fap, the manager

would have to add short term securities. The following table shows the effects of

interest rate changes on different types of Fap.

GA" Canges in Net Inte!est

In,(me

Canges in Ma!*et

1al#e (+ E#ity

6ositive Increase Eecrease

6ositive Eecrease Increase

5egative Increase Increase

5egative Eecrease EecreaseGero Increase Gero

Gero Eecrease Eecrease

"ROBLEMS IN GA" MANAGEMENT

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lthough widely used in practice, Fap, management (whether aggressive or

defensive) has a number of drawbacks. The first complication is the selection of

the time hori#on. s discussed earlier, the separation of assets and liabilities into

rate sensitive and non A rate sensitive requires the establishment of a time hori#on.

lthough necessary, the selection of the time hori#on causes problems because it

ignores the time at which the interest rate sensitive assets are repriced, implicitly

assuming that all rate sensitive assets and liabilities are repriced on the same day.

s eamples of the problem caused by such an assumption, consider a bank which

has #ero Faps. urther assume that the maturity of the rate sensitive assets is one

day, that of the rate sensitive liabilities @


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liability items in order to alter the maturity and therefore the sensitivity of the

portfolio items.

problem related to aggressive Fap management is the need to make interest

rate forecasts. 4ith a lot of assumptions, rate forecast are made and based on these

a number of decision are made. final problem with the Fap management is its

narrow focus on net interest income as opposed to shareholder wealth. n

asset-liability manager may ad+ust portfolio so that the net interest income will rise

with changes in interest income but the value of shareholder wealth may decrease.

ggressive asset-liability management based on interest rate predictions may

increase the risk of loss. If successful, aggressive Fap management may increase

net income but add to the volatility of that income.

ALM "RINCI"LES TAS2 FORCE

The Task orce was comprised of members of the actuarial profession with

eperience in !" in the >nited %tates and 'anada. The !" principles

articulated in this document are applicable to a broad range of entities facing

!"$related issues. The applicability of these principles will depend on the

relevant contet and circumstances of each such entity. lthough the principles

herein are intended to cover a broad range of topics and issues, there may be other

factors not discussed here, and some of the definitions may be interpreted

differently based on the contet of a particular industry under the consideration.

4henever possible, the document attempts to capture these differences, such as in

the case of pension plans and trust funds. 0owever, independent professional

+udgment must be eercised in all situations.

%ince the early work of rank ". &edington in the 89L


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applied actuarial techniques and skills to !" for insurance companies, pension

funds, investment firms, and other financial institutions. To recogni#e this

contribution, the %ociety of ctuaries/ inance 6ractice rea dvancement

'ommittee formed the sset !iability "anagement 6rinciples Task orce (*Task

orce), with the charge to identify and articulate the principles of !".

The original Task orce was formed in 899M and distributed an initial draft

!" 6rinciples document in 899=. t that time, there eisted divergent views on

the central principle of !" A economic value. inancial industry practice at the

time placed greater importance on accounting results rather than economic value,

and this issue was debated at length. "uch has happened since 899=. 3quity

analysts and rating agencies began calling for a more meaningful way to value

companies than the traditional accounting measures. Internationally, pressure

mounted to move to fair value$based accounting standards. ccounting scandals

shed new light on how easily accounting earnings could be manipulated and the

emergence of earnings distorted. The importance of focusing on economic value

was no longer a theoretical argument. revitali#ed Task orce took up the call to

finali#e the !" 6rinciples document in the spring of C


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'harles !. Filbert, 'hairperson

"ark 4. Bursinger

3varonda 'hung

'harles D. ord

Eavid '. Filliland

rederick 4. ackson

3mily O. Oessler

rank . !ongo

osephine 3. "arks

'atherine F. &eimer

"a . &udolph

lbert D. %ekac

6eter E. Tilley

%7 inance 6ractice ctuary Dalentina Isakina

They would also like to acknowledge "ichael . 0ughes (6ast

'hairperson), 'indy orbes, oseph ". &afson, and oseph Tan for their

contributions to the early work of the task force.

This report represents the findings and conclusions of the Task orce.

ASSET-LIABILITY MANAGEMENT DECISIONS IN "RI1ATE

BAN2ING

This research discusses the sources of added$value in private wealth

management, and argues through a series of illustrations that asset$liability

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management is the natural approach for the design of truly client$driven services in

private banking

4orking from the observation that the contribution of asset$liability

management techniques developed for institutional investors is not yet familiar

within private banking, this study shows the epected benefits of a transposition of

that kind.

sset$liability management represents a genuine means of adding value to

private banking that has not been sufficiently eplored to date. 4ithin the

framework of private financial management offerings, personal wealth managerstend to confine their clients to mandates that are only differentiated through their

level of volatility, without the client/s personal wealth constraints and ob+ectives

being genuinely taken into account in order to determine the overall strategic asset

allocation. In that sense, private wealth management is not sufficiently different

from the management of a diversified or profiled mutual fund.

ASSET LIABILITY MANAGEMENT 3ALM4 GUIDELINES FOR

REGIONAL RURAL BAN2S 3RRBS4

&egional &ural Banks (&&Bs) are now operating in a fairly deregulated

environment and are required to determine their own interest rates on deposits and

on their advances which are sub+ect to only the "inimum !ending &ate ("!&)

prescription.

The interest rates on bank/s investments in government and other

permissible securities are also now market related. Intense competition for

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business, involving both the assets and liabilities, together with increasing

volatility in the domestic interest rates and foreign echange rates, has brought

pressure on the management of banks to maintain an optimal balance between

spreads, profitability and long$term viability. The unscientific and ad$hoc pricing

of deposits in the contet of competition, and alternative avenues for the

borrowers, results in inefficient deployment of resources. t the same time,

imprudent liquidity management can put banks/ earnings and reputation at great

risk. These pressures call for a comprehensive approach towards management of

banks/ balance sheets and not +ust ad hoc action. The managements of &&Bs have

to base their business decisions on sound risk management systems with the

ultimate ob+ective of protecting the interest of depositors and stakeholders. It is,

therefore, important that &&Bs introduce effective sset$!iability "anagement

(!") systems to address the issues related to liquidity, interest rate and currency

risks.

s desired by the &BI, the 5B&E has undertaken the task of framing

suitable guidelines on sset$ !iability "anagement (!") for &&Bs. The !"guidelines devised by the 5B&E have been sent to &BI for their formal

approval and thereafter it would be discussed and eplained etensively in the

4orkshops to be organised by 5B&E. The drafts !" Fuidelines prepared by

5B&E are enclosed. %alient features of which are discussed hereunder.

&&Bs are required to put in place an effective !" %ystem, as per the

enclosed Fuidelines, preferably, by @< une C


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Oeeping in view the level of computerisation and the current "I% in many

of the &&Bs, adoption of a uniform !" %ystem by all banks may not be feasible.

The enclosed Fuidelines have been formulated to serve as a benchmark for those

banks which lack a formal !" %ystem. Banks which have already adopted more

sophisticated systems may continue their eisting systems, but should ensure to

fine$tune their current system to ensure compliance with the requirements of the

!" %ystem suggested in the enclosed Fuidelines. 7ther banks should eamine

their eisting "I% and arrange to have an information system to meet the

prescriptions of the !" Fuidelines.

GUIDELINES

'onsidering their structure, balance sheet profile and skill levels of personnel of

&&Bs, &BI and 5B&E found it necessary to provide technical support for

putting in place an effective !" framework. These Fuidelines lay down broad

framework for measuring liquidity, interest rates and fore risks. The initial focus

of the !" function would be to enforce the risk management discipline vi#.

managing business after assessing the risks involved. The ob+ective of good bank

management is to provide strategic tools for effective risk management systems.

&&Bs need to address the market risk in a systematic manner by adopting

necessary sectorA specific !" practices than has been done hitherto. !",

among other functions, also provides a dynamic framework for measuring,

monitoring and managing liquidity, interest rate and foreign echange (fore)

risks. It involves assessment of various types of risks and altering balance sheet

(assets and liabilities) items in a dynamic manner to manage risks.

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ASSET-LIABILITY MANAGEMENT IN COMMERCIAL BAN2S

3ver since the initiation of the process of deregulation of the Indian banking

system and gradual freeing of interest rates to market forces, and consequent

in+ection of a dose of competition among the banks, introduction of asset$liability

management (!") in the public sector banks (6%Bs) has been suggested by

several eperts. But, initiatives in this respect on the part of most bank

managements have been absent. This seems to have led the &eserve Bank of India

to announce in its monetary and credit policy of 7ctober 899: that it would issue

!" guidelines to banks. 4hile the guidelines are awaited, an informal check

with several 6%Bs shows that none of these banks has moved decisively to date to

introduce !".

7ne reason for this neglect appears to be a wrong notion among bankers that

their banks already practice !". s per this understanding, !" is a system of

matching cash inflows and outflows, and thus of liquidity management. 0ence, if a

bank meets its cash reserve ratio and statutory liquidity ratio stipulations regularly

without undue and frequent resort to purchased funds, it can be said to have a

satisfactory system of managing liquidity risks, and, hence, of !".

The actual concept of !" is however much wider, and of greater importance

to banks; performance. 0istorically, !" has evolved from the early practice of

managing liquidity on the bank;s asset side, to a later shift to the liability side,

termed liability management, to a still later realisation of using both the assets as

well as liabilities sides of the balance sheet to achieve optimum resources

management. But that was till the 89:


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functions. The induction of credit risk into the issue of determining adequacy of

bank capital further enlarged the scope of !" in later 89=


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6%Bs. It is suggested that the 6%Bs should introduce !" which would focus on

liquidity management, interest rate risk management and spread management.

Broadly, there are @ requirements to implement !" in these banks, in the stated

order (a) developing a better understanding of !" concepts, (b) introducing an

!" information system, and, (c) setting up !" decision$making processes

(!" 'ommittee-!'7). The above requirements are already met by the new

private sector banks, for eample. These banks have their balance sheets available

at the close of every day. &epeated changes in interest rates by them during the last

@ months to manage interest rate risk and their maturity mismatches are based on

data provided by their "I%. In contrast, loan and deposit pricing by 6%Bs is based

partly on hunches, partly on estimates of internal macro data, and partly on their

competitors; rates. 0ence, 6%Bs would first and foremost need to focus son putting

in place an !" which would provide the necessary framework to define,

measure, monitor, modify and manage interest rate risk. This is the need of the

hour.

ROLE OF RESER1E BAN2 OF INDIA

The &BI, through its credit policy announcements, various directives and

guidelines on !", has spelt out the need for having a comprehensive risk

management policy. The &BI, in its monetary and credit policy and subsequent

guidelines issued in ebruary 8999, recommended that an adequate system of

!" be put in place. The &BI had advised banks in ebruary, 8999 to put in place

an !" system, effective pril 8, 8999 and set up internal sset$!iability

"anagement 'ommittee at the top management level to oversee its

implementation. Banks were epected to cover at least M< percent of their liabilities

and assets in the interim and 8


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lending and refinancing institutions. urther, it even suggested that financial

institutions should introduce !", which would primarily focus on liquidity

management and interest rate risk management. 0aving, thus, laid these

requirements to implement !", in the stated order

() Eeveloping a better understanding of !" concepts

(B) Introducing an !" information system

(') %etting up !" decision A making process (!" committee - !'7), it is

for the institutions to act and implement the same.

CONCLUSION

3mergence of new players, new instruments and new products at competitive

rates in the market following the reform process in India further increased the

bank/s risk. These developments faced the commercial banks to take a re$look on

the assets and liabilities management to remain competitive and withstand the risk

associated with management of asset and liability. The &BI vide its circular dated

ebruary 8C, 899=, advised commercial banks to tighten their asset$liability

management and put in place an appropriate system of asset$liability management.

The &BI has decided to test a model on the few lending banks whereby banks have

been asked to furnish data in a format out$lined by it.

Increasingly banks and asset management companies started to focus on

sset$!iability &isk. The problem was not that the value of assets might fall or that

the value of liabilities might rise. It was that capital might be depleted by

narrowing of the difference between assets and liabilities and that the values of

assets and liabilities might fail to move in tandem. sset$liability risk is

predominantly a leveraged form of risk.

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The capital of most financial institutions is small relative to the firm;s assets or

liabilities, and so small percentage changes in assets or liabilities can translate into

large percentage changes in capital. ccrual accounting could disguise the problem

by deferring losses into

asset liability managment

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