Asset Liability Management in

Banks
Components of a Bank Balance Sheet

Liabilities Assets
1. Capital 1. Cash & Balances
2. Reserve & Surplus with RBI
3. Deposits 2. Bal. With Banks &
4. Borrowings Money at Call and
Short Notices
5. Other Liabilities
3. Investments
4. Advances
5. Fixed Assets
6. Other Assets
Banks profit and loss account

A bank’s profit & Loss Account has the

following components:

I. Income: This includes Interest Income

and Other Income.
II. Expenses: This includes Interest
Expended, Operating Expenses and
Provisions & contingencies.
What is Asset Liability Management??

 The process by which an institution manages its

balance sheet in order to allow for alternative
interest rate and liquidity scenarios

 Banks and other financial institutions provide

services which expose them to various kinds of
risks like credit risk, interest risk, and liquidity risk

 Asset-liability management models enable

institutions to measure and monitor risk, and
provide suitable strategies for their management.
Evolution of ALM
 In the 1940s and the 1950s, there was an abundance of funds
in banks in the form of demand and savings deposits. Hence,
the focus then was mainly on asset management

 But as the availability of low cost funds started to decline,

liability management became the focus of bank management
efforts

 In the 1980s, volatility of interest rates in USA and Europe

caused the focus to broaden to include the issue of interest
rate risk. ALM began to extend beyond the bank treasury to
cover the loan and deposit functions

 Banks started to concentrate more on the management of both

sides of the balance sheet
 Asset Management
 Asset Management: the attempt to earn the
highest possible return on assets while
minimizing the risk.
1. Get borrowers with low default risk, paying high
interest rates
2. Buy securities with high return, low risk
3. Diversified portfolio
4. Manage liquidity
 Asset Management - Credit Risk:
Overcoming Adverse Selection and Moral Hazard

 Screening and information collection

 Specialization in lending (e.g. energy
sector)
 Diversification - by industry and
geography
 Monitoring and enforcement of
restrictive covenants
 Long-term customer relationships
 Collateral and compensating balances
 An effective Asset Liability Management Technique aims to
manage the volume, mix, maturity, rate sensitivity, quality and
liquidity of assets and liabilities as a whole so as to attain a
predetermined acceptable risk/reward ratio

 It is aimed to stabilize short-term profits, long-term earnings

and long-term substance of the bank. The parameters for
stabilizing ALM system are:
1. Net Interest Income (NII)
2. Net Interest Margin (NIM)
3. Economic Equity Ratio
3 tools used by banks for ALM

ALM information systems

ALM Organization

ALM Process
ALM Information Systems
 Usage of Real Time information system to gather the
information about the maturity and behavior of loans and
advances made by all other branches of a bank

 ABC Approach :
 analysing the behaviour of asset and liability products in
the top branches as they account for significant business
 then making rational assumptions about the way in which
assets and liabilities would behave in other branches
 The data and assumptions can then be refined over time as
the bank management gain experience

 The spread of computerisation also help banks in

accessing data.
ALM Organization
 The board should have overall responsibilities and should set the limit for
liquidity, interest rate, foreign exchange and equity price risk

 The Asset - Liability Committee (ALCO)

 ALCO, consisting of the bank's senior management (including CEO)
should be responsible for ensuring adherence to the limits set by the
Board
 Is responsible for balance sheet planning from risk - return perspective
including the strategic management of interest rate and liquidity risks
 The role of ALCO includes product pricing for both deposits and
advances, desired maturity profile of the incremental assets and
liabilities,
 It will have to develop a view on future direction of interest rate
movements and decide on a funding mix between fixed vs floating rate
funds, wholesale vs retail deposits, money market vs capital market
funding, domestic vs foreign currency funding
 It should review the results of and progress in implementation of the
decisions made in the previous meetings
ALM Organisation
 Board should have overall responsibility for management of risk
 Board should decide risk management policy and procedure, set
prudential limits, auditing, reporting and review mechanism in respect of
liquidity, interest rate and forex risk
 ALCO
 Consisiting of bank’s senior management including CEO
 Responsible for adherence to the polices and limits set by Board
 Responsible for deciding business strategies (on asset liability side) in
line with bank’s business and risk objectives
 ALM Support Group
 Consisting of operating staff
 Responsible for analysing, monitoring and reporting risk profiles to ALCO
 Prepare forecasts showing effects of various possible changes in market
conditions affecting balance sheet and suggesting action to adhere to
bank’s internal limits

05/03/2020
ALM Organisation (Contd.)

 ALCO decision making unit responsible for

 Balance Sheet planning from risk-return perspective which includes
management of liquidity, interest rate and forex risks
 Pricing of deposits and advances, desired maturity profile etc.
 Monitoring the risk levels of the bank
 Review of the results and progress of implementation of decisions made
in previous meeting
 Future business strategies based on bank’s current view on interest rates
 To decide on source and mix of liabilities or sale of assets
 To develop future direction of interest rate movements
 To decide on funding mix between fixed and floating rate funds,
wholesale vs. retails deposits, short term vs. long term deposits etc.

05/03/2020
ALM Process

Risk Parameters

Risk Identification

Risk Measurement

Risk Management

Risk Policies and

Tolerance Level
Categories of Risk
 Risk is the chance or probability of loss or
damage
Credit Risk Market Risk Operational Risk

Transaction Risk Commodity risk Process risk

/default risk
/counterparty risk
Portfolio risk Interest Rate risk Infrastructure risk
/Concentration risk
Settlement risk Forex rate risk Model risk

Equity price risk Human risk

Liquidity risk
But under ALM risks that are typically
managed are….

Liquidity
Currency Risk
Risk
Intere
st
Rate
Risk

Will now be discussed in detail

Liquidity Risk
 Liquidity risk arises from funding of long term assets by
short term liabilities, thus making the liabilities subject to
refinancing

Funding • Arises due to unanticipated

withdrawals of the deposits from
risk wholesale or retail clients

Time • It arises when an asset turns into a

NPA. So, the expected cash flows
risk are no longer available to the bank.

• Due to crystallisation of contingent

Call liabilities and unable to undertake
Risk profitable business opportunities
when available.
Liquidity Risk Management
 Bank’s liquidity management is the process of generating
funds to meet contractual or relationship obligations at
reasonable prices at all times

 Liquidity Management is the ability of bank to ensure that

its liabilities are met as they become due

 Liquidity positions of bank should be measured on an

ongoing basis

 A standard tool for measuring and managing net funding

requirements, is the use of maturity ladder and
calculation of cumulative surplus or deficit of funds as
selected maturity dates is adopted
Statement of Structural Liquidity
All Assets & Liabilities to be reported as
per their maturity profile into 8
maturity Buckets:
i. 1 to 14 days
ii. 15 to 28 days
iii. 29 days and up to 3 months
iv. Over 3 months and up to 6 months
v. Over 6 months and up to 1 year
vi. Over 1 year and up to 3 years
vii. Over 3 years and up to 5 years
viii. Over 5 years
 Statement of structural liquidity
 Places all cash inflows and outflows in the maturity ladder as
per residual maturity

 Maturing Liability: cash outflow

 Maturing Assets : Cash Inflow

 Classified in to 8 time buckets

 Mismatches in the first two buckets not to exceed 20% of

outflows

 Shows the structure as of a particular date

 Banks can fix higher tolerance level for other maturity buckets.
 Addressing the mismatches

 Mismatches can be positive or negative

 Positive Mismatch: M.A.>M.L. and Negative Mismatch

M.L.>M.A.

 In case of +ve mismatch, excess liquidity can be deployed in

money market instruments, creating new assets &
investment swaps etc.

 For –ve mismatch, it can be financed from market

borrowings (Call/Term), Bills rediscounting, Repos &
deployment of foreign currency converted into rupee.
 Interest Rate Risk

 Interest Rate risk is the exposure of a bank’s financial

conditions to adverse movements of interest rates

 Though this is normal part of banking business, excessive

interest rate risk can pose a significant threat to a bank’s
earnings and capital base

 Changes in interest rates also affect the underlying value

of the bank’s assets, liabilities and off-balance-sheet item

 Interest rate risk refers to volatility in Net Interest Income

(NII) or variations in Net Interest Margin(NIM)

 NIM = (Interest income – Interest expense) / Earning

assets
Reasons for Interest Rate Risk
 On account of asset transformation
 Many deposits are used for one big loan
 Periodical review of assets and liabilities
 Due to mismatches between maturity /
repricing dates as well as maturity
amounts between assets and liabilities
 Depositors and borrowers may pre-close
their accounts

College of Agricultural Banking, RBI, 05/03/2020

PUNE
Currency Risk
 The increased capital flows from different nations following
deregulation have contributed to increase in the volume of
transactions

 Dealing in different currencies brings opportunities as well as

risk

 To prevent this banks have been setting up overnight limits

and undertaking active day time trading

 Value at Risk approach to be used to measure the risk

associated with forward exposures. Value at Risk estimates
probability of portfolio losses based on the statistical analysis
of historical price trends and volatilities.
Foreign Exchange Exposure and Risk and Risk Management
 Exposure refers to the degree to which a bank is affected
by exchange rate changes.
 Exchange rate risk is defined as the variability of a firm’s
value due to uncertain changes in the rate of exchange.
 Managing Foreign Exposure with the concept of Risk
Management is called Hedging.

Entering into an offsetting currency position so whatever

is lost/gained on the original currency exposure is
exactly offset by a corresponding currency gain/loss on
the currency hedge.
Insuring Against Foreign Exchange Risk
The foreign exchange market can be used
to provide insurance to protect against
foreign exchange risk (the possibility that
unpredicted changes in future exchange
rates will have adverse consequences for
the firm)
A firm that insures itself against foreign
exchange risk is hedging
Risk Monitoring.
 Risk monitoring processes are established
to evaluate the performance of bank’s risk
strategies/policies and procedures in
achieving overall goals.
 Reporting of risk measures should be
regular and should clearly compare current
exposures to policy limits. Further past
forecast or risk estimates should be
compared with actual results to identify
any shortcomings in risk measurement
techniques.
Risk Control
 Bank’s internal control structure ensures
the effectiveness of process relating to
market risk management.
 Persons responsible for risk monitoring and
control procedures should be independent
of the functions they review.
 Key elements of internal control process
include internal audit and review and an
effective risk limit structure.