FINANCIAL SYSTEMS AND SERVICES UNIT 3: ASSET LIABILITY MANAGEMENT ASSET LIABILITY MANAGEMENT: INTRODUCTION The bond portfolio

of any bank bears a loss due to the unexpected changes in the interest rate. The implication of Interest Rate Risk has become more passive and goes far beyond the investment portfolio, extending to the entire balance sheet and P&L account. Thus managing the interest rate risk has become a strategic objective of banks and financial institutions. The interest rate risk affects the 2 areas of the bank:

NII (Net Interest Income)

MVE (Market Value of Equity)

To manage the Interest Rate risk two distinct approaches which were adopted by bank:

Asset Management Approach Liability Management Approach The comprehensive form is called ASSET- LIABILITY MANAGEMENT APPROACH, which considers the management of Interest Rate Risk. NII (Net Income Interest) Banks, as a part of their business of intermediation between the savers and investors in the economy, assumes liabilities and create assets which are of different maturities and sizes. The liabilities and assets are priced differently and the difference between the interest received on assets and the interest paid on liabilities is the banks net interest income. MVE (Market Value of Equity) The Market Value of Equity is also called the Market Value of Net Worth. It is given by the difference between the market values of assets and liabilities,

which implies that all the items of assets and liabilities of bank are exposed to price risk. Price risk will impact the values of assets and liabilities of the bank and in turn, the Market Value of Equity. Price risk is the change in the price of investment with the change in the interest rate. The value of the investment changes inversely to the interest rates. Thus, if interest rate in market increases, the investment suffers depreciation. Interest can be viewed as the compensation received by a saver who postpones his present consumption to a future date for higher consumption. Thus, the Interest Rate should be of such magnitude that it would later enable the saver or a financial investor to enjoy higher consumption. Secondly, a rupee today is more valuable than a rupee tomorrow. This is the concept of Time Value of Money. The erosion in the purchasing power on account of inflation should be taken into account. In addition to the sacrifice of consumption and risk of erosion is value that are involved in saving, the saver (lender) is exposed to the risk of default by the borrower and will expect to be additionally compensated to commensurate with the magnitude of the perceived risk. Assets Management strategy: Some banks had traditional deposit base and were also capable of achieving substantial growth rates in deposits by active deposit mobilization drive using their extensive branch network. For such banks, the major concern was how assets can be expanded securely and profitably credit was the major key decision area for the bank management while investment activity was driven by the need to maintain statutory liquidity ratio or as a function of liquidity management. The management strategy in such banks thus was biased towards asset management. In fact, the aspects of maturity and cost of deposits/ non deposits being raised were not critical in a regime of regulated interest rates on deposits and advances. Liability Management Strategy: A few banks, on the other hand, were incapable of achieving retail deposit growth comparable with those banks having wide branch network. But these banks possessed good asset management skills and as such were capable of superior performance provide they could fund the assets relying on wholesale market (Calls, CDs, Bill Rediscounting etc.). deregulation of interest rates presented them an opportunity to compete for funds from the

wholesale market using the pricing strategy to achieve the desired volume, mix and cost. Gradually, even those banks which were predominantly adopting Asset Management Approach realized the importance of liability management. Deregulation of interest rates, coupled with reforms in money market introduced by the Reserve Bank, made it possible for banks to be competitive in the borrowing and lending operations. Under the liability management approach, banks primarily sought to achieve the maturities an volumes of funds by flexibly changing their bid rates for funds.

Asset Liability Management Strategy: As interest rates both on the assets and liabilities side were deregulated, thus interest rate in market segments such as call money, CD etc tended to be volatile i.e.; turned variable over a period of time because of competition. Now the banks to keep aligned with these market rates need to change their interest rates. As a result IRR levels heightened for banks. Consequently, the need to adopt a comprehensive ALM Strategy clearly emerged. Asset Liability Management is concerned with strategic balance sheet management involving risks caused by changes in interest rates, exchange rate, credit risk and the liquidity position of bank, with profit becoming a keyfactor. It has now become imperative for banks to move towards integrated balance sheet management where components of balance sheet (i.e.; all the components not assets and liabilities individually) and its different maturity mix will be looked at profit angle of the bank. PURPOSE AND OBJECTIVES OF ASSET LIABILITY MANAGEMENT To achieve the short and long term goals, the volume, mix and returns of both liabilities and assets need to be planned and monitored. To control all the business segments of the bank (such as deposits, borrowing, credit, investments, derivatives, foreign exchange etc.). Review the interest rate structure and compare the same to the interest pricing of both assets and liabilities. Examine the loan and investment portfolios in the light of the foreign exchange risk and liquidity risk that might arise.

 Examine the credit risk and contingency risk that may originate either due to rate fluctuations or otherwise and assess the quality of assets. Review, the actual performance against the projections made and analyse the reasons for any effect on spreads.

COMPONENTS OF ASSETS & LIABILITIES IN BANKS BALANCE SHEET AND THEIR MANAGEMENT Banks Liabilities The sources of funds for the lending and investment activities constitute liabilities side of balance sheet. Capital Reserves and Surplus Deposits Borrowings Other Liabilities and Provisions Contingent Liabilities. Interest rate sensitive and non sensitive (examples)
Notes , bonds and debentures: Sensitive; reprice on the repricing date,

should be slotted in respect time buckets, as per repricing dates.

Deposits/ borrowings : Sensitive; could reprice on maturity or in case of

premature withdrawal.
Capital, Reserves and surplus: non- sensitive.

Time buckets set by RBI: 1-28 days 30 days 3 months

3- 6 months 6 months 1 year 1 year 3 years 3 years 5 years 5 years and above Non Sensitive Examples indicating which Interest Rate Sensitive Assets and Liabilities fall in which Time Bucket Inflows: Current account: 6 months 1 year Deposits: as per residual maturity Outflows: Capital funds: i. ii. iii. iv. Equity capital, preference capital etc.: over 5 years Gifts, donation: over 5 years borrowings (banks, working capital loan cash, credits): 6 months1 year Notes, bonds & debentures : as per the residual maturity of instrument

ALM PROCESS The process consists of five fundamental steps: 1. Assess the entitys Risk / reward objectives: The purpose of ALM is not necessarily to eliminate or even minimize risk. The level of risk will vary with the return requirement and entitys objectives. Financial objectives and risk tolerances are generally determined by senior management of an entity and are reviewed from time to time. 2. Identify risks:

All sources of risk are identified for all assets and liabilities. Risks are broken down into their component pieces and the underlying causes of each component are assessed. Relationships of various risks to each other and/or to external factors are also identified. 3. Quantify the level of risk exposure: Risk exposure can be quantified 1) relative to changes in the component pieces, 2) as a maximum expected loss for a given confidence interval in a given set of scenarios, or 3) by the distribution of outcomes for a given set of simulated scenarios for the component piece over time. Regular measurement and monitoring of the risk exposure is required. 4. Formulate and implement strategies to modify existing risks: ALM strategies comprise both pure risk mitigation and optimization of the risk/reward tradeoff. Risk mitigation can be accomplished by modifying existing risks through techniques such as diversification, hedging, and portfolio rebalancing. For a given risk tolerance level, a given set of investment opportunities, and a given set of constraints, optimization ensures that the portfolio has the most desirable risk/reward tradeoff. Optimization 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 ALM analysis. Practitioners are cautioned not to put undue reliance on the results of a mechanical calculation. Professional judgment is an important part of the process. 5. Monitor risk exposures and revise ALM strategies as appropriate: ALM is a continual process. All identified risk exposures are monitored and reported to senior management on a regular basis. If a risk exposure exceeds its approved limit, corrective actions are taken to reduce the risk exposure. For pension plans, monitoring current financial status and possible short-term outcomes is very helpful in managing pension risk. Operating within a dynamic environment, as the entitys risk tolerances and financial objectives change, the existing ALM strategies may no longer be appropriate. Hence, these strategies need to be periodically reviewed and modified. A formal, documented communication process is particularly important in this step. GAP ANALYSIS:

Objectives: To identify Interest Rate Sensitive Assets (RSA) & Interest Rate Sensitive Liabilities (RSL) in the balance sheet To quantify Interest Rate risk by working out Interest Sensitive Gap To describe the effect of rise or decline of interest rate on the projected NII during a given performance horizon To identify the risk involved due to Interest Sensitivity Gap Interest Sensitive Gap Analysis (also known as gap analysis) is the most popular analytical tool used by bank management to hedge the balance sheet from interest rate risk. While the traditional Gap analysis seeks to manage risk arising from mis-matches in repricing of assets and liabilities. Traditional Gap Analysis involves an analysis & management of the banks positions in interest sensitive assets & liabilities items. The Gap Analysis usually covers the performance period adopted by the bank for its performance planning. While ideally such repricing gaps may be worked out on daily basis. A simpler method is adopted in practice whereby assets & liabilities as on the reference date are grouped as per the repricing maturities under pre-defined Time Buckets. The choice of the length & the number of time buckets will depend upon the nature of activity of the financial institution. The difference between the book values of assets & liabilities repricing in a particular time bucket is called the Repricing Gap or Interest Sensitive Gap. Repricing Gap is a measure of risk as it signifies the magnitude of excess of assets over liabilities (or vice versa) which would get repriced at different interest rate if interest rate changes. If the management feels that in any bucket the Repricing Gap is high & signifies a higher interest rate risk exposure, it will try to reduce such gaps. Thus, a bank can hedge itself against interest rate changes, no matter which way the rates move, by making sure for each time bucket that the volume of repriceable interest sensitive assets approximately equals the volume of repriceable interest sensitive bank liabilities. The starting point of Gap Analysis is therefore, to decide on the time buckets & identification of interest rate sensitive assets & liabilities.

Example: A bank with interest sensitive assets of 60 cr. & interest sensitive liabilities of 40 cr. Which fall due to repricing during a particular time bucket is asset sensitive with a positive gap of 20 cr. If IR rise, the banks NII will increase, because more of banks assets will reprice at a higher rate than liabilities and therefore, revenue will increase more than the cost of borrowed funds. On the other hand, if IR falls when the bank is asset sensitive the banks NII will decline as interest revenues from the repriced assets drop by more than interest rate expenses associated with the repriced liabilities. Similarly if the interest sensitive liabilities exceed the interest rate sensitive assets due for repricing in a particular time bucket, the bank is said to be liability sensitive or negatively gapped during that time bucket. The impact on NII resulting from the changes in the IR will be exactly opposite to those for positive gap. The important assumption here is that the extent of rise in IR both on the asset and liability side will be same & concurrent across time. The adverse impact on NII is calculated by multiplying the gaps with the expected change in interest rates.

Example: GAP Positive ASSETS Positive Cash 1-28 days INTEREST 3 6 6mont MoreON NII IMPACT 29 days RATE NonCHANGE 3mnth month hs 1 than 1 sensi s yr yr Increases Positive tive Decreases Increases Negative 20 Negative 500 Positive 600 1100 600 620 tota l

100 400 500

20 20 960 282 0 600

Deposits with 20 Negative bank 180 Negative Investments 1200 Loans Premises 1400

100 80 Decreases 300 320 400 400

Total

442 0

LIABILITIES C/D S/D Term deposits Borrowings Othr liabilities Net worth Total 600 800 100 400 1900 200 100 300 200 800 500 500 200 200 200 200 20 100 700 820 820 900 130 0 700 700 442 0 Interest rate -500 sensitive gap Cumulative gap -500 -400 -100 +300 +900 -200

-900

-1000

-700

+200

Let us assume that at the time of repricing of assets/ liabilities, the IR moves up by 1% Then, the reduction in NII will be = 500 * 0.01 * (11.5/12) Now, if the first gap is left unattended, it would entail a reduction in NII = 4.79 cr. Similar calculations are made in respect of other relevant gaps also. SEVERAL METHODS TO MEASURE A BANKS INTEREST SENSITIVE GAP:

First is the Repricing Gap; difference between interest sensitive assets (ISA) and interest sensitive liabilities (ISL) within a time bucket. i.e.; a bank whose gap is positive is asset sensitive and a bank which has a negative gap is liability sensitive. Suppose a bank has 600 cr. of ISA repricing in a time bucket and 500 cr. of ISL repricing in the same time bucket, the Interest Sensitive Gap is of 100 cr. Another way to express the IRR position is calculating the Relative-Interest Sensitive Gap Ratio of the Interest Sensitive Gap to Total assets. In the same example the Relative IS Gap will work out to +100/600 = +0.17 A Relative IS Gap greater than zero means the bank is asset sensitive, while a negative IS Gap indicates that the bank is liability sensitive. A third method to quantify the IRR is to calculate the Interest Sensitivity Ratio (IS ratio) which is nothing but the ratio of ISA and ISL. In the same example the IS ratio will work out to 600/500 = 1.2. If the IS Ratio is more than one the bank is asset sensitive and if the ratio is less than one the bank is liability sensitive. SHORTCOMINGS OF GAP ANALYSIS: i. Basically a balance sheet concept & captures only principal assets and liabilities- revenue flows are ignored. ii. Static analysis; business growth is not taken into account. iii. Assumes parallel shift in the yield curve. iv. Does not take into account the time value of money. v. Emphasis on short term and NII. vi. Ignores sensitivity of non-paying assets and liabilities. vii. The bucketing is rather arbitrary and there could be mis-matches within the time bucket. viii. Forecasting of interest rate difficult-though essential. DURATION:

When the market interest rates rise the prices of existing bonds decreases (depreciation) and when the interest rates decline the prices of the bonds increases(appreciation). It can however ,be shown that changes in the bond values depends upon factors which are both exogenous to the security (change in market interest rates popularly called Yields) and endogenous to the security (coupon rate. Frequency of payment of coupons and the remaining term to maturity of bond). This dependence of price changes to the multitude of variables makes the assessment of the possible price changes due to changes in interest rate rather cumbersome when all variable change. The concept of duration is helpful to get over the above problem. Duration of the coupon bearing bond is weighted average maturity of its cash flow streams in present value terms. It can also be described as the maturity of an equivalent Zero Coupon Bond. Duration is calculated using the following formula: Duration = [PV(C )*1+PV(C )*2+PV(C )*3+.+PV(C ). +PV(C )*n] V0 Where PV(C )= present value of cash flow receivable at the end of year t (t=1,2,3n)