ASSET LIABILITY MANAGEMENT MODULE A C.S.BALAKRISHNAN FACULTY MEMBER,SPBT COLLEGE

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ASSET LIABILITY MANAGEMENTMODULE
AC.S.BALAKRISHNANFACULTY MEMBER,SPBT COLLEGE
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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.

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• Banks Assets are the funds mobilised by bank
  through various sources.
• -Cash and Bank balances with Reserve Bank
• Of India.
• -Balances with banks and money at call and
• short notice.
• -Investments
• -Advances
• -Fixed Assets
• -Other Assets.

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• Business of banking involves the
  identifying,measuring,accepting and managing the
  risk,the heart of bank financial management is
  risk management.One of the most important
  risk-managemnet functions in bank is Asset
  Liability Management.
• Traditionally,administered interest rates were
  used to price the assets and liabilities of
  banks.However,in the deregulated
  environment,competition has narrowed the spreads
  of banks.

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• 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
  key-factor,it has now become imperative for banks
  to move towards integrated balance sheet
  management where components of balance sheet and
  its different maturity mix will be looked at
  profit angle of the bank.

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• ALM is about management of Net Interest
  Margin(NIM) to ensure that its level and
  riskiness are compatible with risk/return
  objectives of the bank.It is more than just
  managing individual assets and liabilities.It is
  an integrated approach to bank financial
  management requiring simultaneous decision about
  types and amount of financial assets and
  liabilities it holds or its mix and volume.In
  addition ALM requires an understanding of the
  market area in which the bank operates.

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• If 50 of the liabilities are maturing within 1
  year but only 10 of the assets are maturing
  within the same period.Though the financial
  institution has enough assets,it may become
  temporarily insolvent due to a severe liquidity
  crisis.
• Thus,ALM is required to match assets
  liabilities and minimise liquidity as well as
  market risk.

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• Reasons for growing significance of ALM
• -Volatility
• -Product Innovation
• -Regulatory Framework
• -Management Recognition
• 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.

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• Purpose and objectives of asset liability
• management
• Review the interest rate structure and compare
  the same to the interest/product 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.

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• Review,the actual performance against the
  projections made and analyse the reasons for any
  effect on spreads.
• Aim is to stabilise the short-term
  profits,long-term earnings and long-term
  substance of the bank.The parameters that are
  selected for the purpose of stabilising asset
  liability management of banks are
• -Net Interest Income(NII)
• -Net Interest Margin(NIM)
• -Economic Equity Ratio

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• Net Interest Income-
• Interest Income-Interest Expenses.
• Net Interest Margin-
• Net InterestIncome/Average Total Assets
• Economic Equity Ratio-
• The ratio of the shareholders funds to the total
• assets measures the shifts in the ratio of owned
  
• funds to total funds.The fact assesses the
• sustenance capacity of the bank.

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• ALM is required to match assets and liabilities
• to ---------liquidity risk as well as market
  risk.
• The ratio of shareholders funds to the total
  assets is called-------.
• Net Interest Margin is defined as net interest
  income divided by ---------.
• Liquidity is ensured by grouping the
  assets/liabilities based on their ------.
• The institution is in a position to benefit from
  rising interest rates when assets are ------ than
  liabilities

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• State True or False
• Assets represent source of funds whereas
  liabilities denote the use of funds in a balance
  sheet.
• Deregulated environment has narrowed spreads of
  the banks.
• Asset liability management is only management of
  maturity mismatch and has no bearing on profit
  augmentation.
• Net Interest Margin is known as Spread

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LIQUIDITY MANAGEMENT

• Banks need liquidity to meet deposit withdrawal
  and to fund loan demands.
• The variability of loan demands and variability
  of deposits determine banks liquidity needs.It
  represents the ability to accommodate decreases
  in liability and to fund increases in assets.
• It demonstrates the market place that the bank is
  safe and therefore capable of repaying its
  borrowings.

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• It enables bank to meet its prior loan
  commitments,whether formal or informal.
• It enables bank to avoid the unprofitable sale of
  assets.
• It lowers the size of the default risk premium
  the bank must pay for funds.
• Types of liquidity risk
• -Funding Risk
• -Time Risk
• -Call Risk.

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• Funding Risk
• Need to replace net outflows due to
  unanticipated withdrawal/non-renewal of deposits
  arises due to -Fraud causing substantial loss
• -Systemic Risk
• -Loss of confidence
• -Liabilities in foreign currencies

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• Time Risk
• Need to compensate for non-receipt of
  expected inflow of funds,arises due to,
• -Severe deterioration in the asset quality
• -Standard assets turning into non-performing
  
• assets
• -Temporary problems in recovery
• -Time involved in managing liquidity.

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• Call RiskCrystallisation of contingent
  liabilities and inability to undertake profitable
  business oppurtunities when desirable,arises due
  to,
• -Conversion of non-fund based limit into fund
  
• based.
• -Swaps and options.

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• Measuring and Managing Liquidity Risk
• Developing a structure for managing liquidity
  risk.
• Setting tolerance level and limit for liquidity
  risk.
• Measuring and managing liquidity risk.

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• Setting tolerance level for a bank
• To manage the mismatch levels so as to avert
  wide liquidity gaps-The residual maturity profile
  of assets and liabilities will be such that
  mismatch level for time bucket of 1-14 days and
  15-28 days remain around 20 of cash outflows in
  each time bucket.
• To manage liquidity and remain solvent by
  maintaining short-term cumulative gap up to one
  year(short term liabilities-short term assets at
  15 of total outflow of funds.

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• Measuring and Managing Liquidity Risk
• Stock Approach
• Flow Approach
• Stock Approach is based on the level of
  assets and liabilities as well as off balance
  sheet exposures on a particular date.The
  following ratios are calculated to assess the
  liquidity position of the bank
• Ratio of core deposits to total assets
• Net loans to total deposits ratio
• Ratio of time deposits to total deposits
• Ratio of volatile liabilities to total assets
  

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• Ratio of short term liabilities to liquid assets
• Ratio of liquid assets to total assets
• Ratio of short term liabilities to total assets
• Ratio of prime assets to total assets
• Ratio of market liabilities to total assets.
• Flow Approach
• -Measuring and managing net funding
• requirements.
• -Managing Market Access
• -Contingency Planning

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• Measuring and Managing net funding
• Requirements
• Flow method is the basic approach followed by
• Indian Banks.It is called as gap method of
• measuring and managing liquidity.It requires the
• preparation of structural liquidity gap report.In
  
• this method net funding requirement is
• calculated on the basis of residual maturiries of
  
• assets liabilities.These residual maturities
• represent net cash flows ie.difference between
  cash
• outflow cash inflow in future time buckets

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• These calculations are based on the past
  behaviour pattern of assets and liabilities as
  well as off balance sheetexposures.Cumulative gap
  is calculated at various time buckets.In case gap
  is negative bank has to manage the shortfall.
• The analysis of net funding requirements involves
  the construction of a maturity ladder and the
  calculation of a cumulative net excess or deficit
  of funds at selected maturity dates.

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• Objective of liquidity management is to
• a)Ensure profitability
• b)Ensure liquidity
• c)Either of two
• d)Both
• Banks need liquidity to
• a) Meet deposit withdrawal
• b) Fund loan demands
• c) Both of them
• d) None of them.

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• Adequacy of a banks liquidity position depends
  upon
• a)Sources of funds
• b)Anticipated future funding needs
• c)Present and Future earnings capacity
• d)All the above

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• The need to replace net outflows due to
  unanticipated withdrawal of deposits is known as
  ---------risk.
• The need to compensate for non-receipt of
  expected inflows of funds is classified as
  -----risk.
• Call risk arises due to crystallisation of
  ------.
• Maturity ladders enables the bank to estimate the
  difference between-----and------in predetermined
  periods.

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• Liquidity management methodology of evaluating
  whether a bank has sufficient liquid funds based
  on the behaviour of cash flows under different
  what if scenarios is known as -------.
• The capability of bank to withstand a net
  funding requirement in a bank specific or general
  market liquidity crisis is denoted as----

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INTEREST RATE RISK MANAGEMENT
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• Interest rate risk is the volatility in net
  interest income(NII) or in variations in net
  interest margin(NIM).
• GapThe gap is the difference between the amount
  of assets and liabilities on which the interest
  rates are reset during a given period.
• Basis riskThe risk that the interest rate of
  different assets and liabilities may change in
  different magnitudes is called basis risk.
• Embedded optionPrepayment of loans and bonds
  and/or premature withdrawal of deposits before
  their stated maturity dates.

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• Yield curveIt is a line on a graph plotting the
  yield of all maturities of a particular
  instrument.
• Changes in interest rates also affect the
• underlying value of the banks--------
• Rise in interest rates-----the market value of
  that
• asset and fall in interest rate ----the market
  value
• of assets or liabilities.
• The gap is the difference between the amount
• of assets and liabilities on which interest rates
  
• are------during a given period

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• Mismatch occurs when assets and liabilities fall
  due for -----in different periods
• The economic value of a bank can be viewed
• as the present value of the banks expected
• -------.
• Estimates derived from a standard duration
  generally focus on just one form of interest rate
  risk exposure ie.-----
• The adverse impact on NII due to mismatches
  can be minimised by fixing appropriate ----on
  interest rate sensitivity gaps.

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Management of Exchange Rate Risk
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• Foreign exchange risk-Risk arising out of adverse
  exchange rate movementsduring a period in which
  it has open position in an individual foreign
  currency.
• Transaction exposureChange in the foreign
  exchange rate between the time the transaction is
  executed and the time it is settled.
• Forwards-Agreement to buy or sell forex for a
  predetermined amount,at a predetermined rate on a
  predetermined date.

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• Open positionThe extent to which outstanding
  contracts to purchase a currency exceed
  liabilities plus outstanding contractsto sell the
  currency vice versa.
• Overnight position-A limit on the maximum open
  position left overnight,in all major currencies.
• Day-light position-A limit on maximum open
  position in all major currencies at any point of
  time during day.Such limits are generally larger
  than overnight positions.

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• OptionsIt is a contract for future delivery of a
  currency in exchange for another,where the holder
  of the option has the right,without obligation to
  buy or sell the currency at an agreed price,the
  strike price or exercise price,on a specified
  future date.
• Call optionThe right to buy under an option
• Put optionThe right to sell under an option.
• Futures are forward contracts with standardized
  size,standardised maturity date governed by a set
  of guidelines stipulated by exchange concerned
  for settlements and payments.

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• An appreciation in domestic currency will----
• value of assets and liabilities.
• In a forward contract actual cash flow occurs on
• the date of-----
• Swaps can be of two types----and------

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• RBI GUIDELINES

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• Any questions

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• Thank you

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