ALM and

Fund Management
Banks get affected by
 Actions of Central Banks
 Actions of the Government
 Domestic and International
Disturbances
 Inflation
Deregulation
 Banks are now operating in a fairly
deregulated environment and are
required to determine on their own,
interest rates on deposits and
advances
 Intense competition for business
involving both the assets and liabilities
together with increasing volatility in the
interest rates has brought pressure on
the management of banks to maintain
a good balance among spreads
Risks Faced by Banks
 Credit Risk
 Market Risk
 Liquidity Risk
 Interest Rate Risk
 Operational Risk
Effects of Risk Factors
 Loss of Market Value
 Loss of Reserves
 Loss of stakeholders confidence
ALM
 The ALM guidelines issued by RBI has
been formulated to serve as a
benchmark for banks which lack a
formal ALM system
 Those who already have their existing
system may fine tune their information
and reporting system
Purpose of ALM
 Capture the maturity structure of the
cash flows (inflows and outflows) in
the Statement of Structural Liquidity
 Tolerance levels for various maturities
may be fixed by the bank keeping in
view bank’s ALM profile, extent of
stable deposit base, nature of cash
flows etc.
ALM
 ALM is about managing market risk
and liquidity risk together
 Capital market exposure of banks is
small
 Exchange risk is highly specialized
 Hence ALM is an integrated risk
management approach for managing
liquidity risk, interest rate risk
The problem of mismatch
 Mismatches in maturity
 Mismatches in interest rate
 How does bank makes the spread?
 Borrow short and lend long and keep
the spread
 Maturity mismatch is the basis of
profitability
 Risk management does not eliminate
mismatch – merely manages them
The problem of mismatch
 Interest Rate Risk  Affects
profitability
 Liquidity Risk  May lead to
liquidation
 General Strategy
◦ Eliminate Liquidity Risk
◦ Manage Interest Rate Risk
Asset Liability Transformation
 Banks are exposed to credit and
market risks in view of the asset-
liability transformation
 With liberalisation, banks’ operations
have become complex and large ,
requiring strategic management
ALM Pillars
 ALM Information Systems
 ALM Organisation
 ALM Process
ALM Pillars (Contd.)

 ALM Information systems

◦ MIS
◦ Information availability
◦ Accuracy
◦ Adequacy
◦ Expediency
ALM Pillars (Contd.)

 ALM Organisation
◦ Structure and responsibilities
◦ Level of top management involvement
ALM Pillars (Contd.)

 ALM Process
 Risk Parameters
 Risk Identification
 Risk Measurement
 Risk Management
 Risk Policies and Procedures,
prudential limits and auditing,
reporting and review
ALM Information Systems
 ALM framework built on sound
methodology with necessary
information system back-up
 ALM to be supported by management
philosophy and clearly states risk
policies and procedures / prudential
limits
 Banks may utlilise ‘Gap Analysis’ or
‘Simulation’
 Important to have availability of timely,
adequate and accurate information
ALM Information Systems (Contd.)

 ALM Data could be developed by

following approach, in case banks do
not have requisite information
◦ Analyse behaviour of asset and liability
products in sample branches that account
for significant business (60-70 per cent)
◦ Based on this make rational assumption
for the other branches
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
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.
ALM Organisation (Contd.)

 ALCO size would be dependent on the

size of the UCB
 May comprise of
◦ CEO or Secretary
◦ Chief of Investment / Treasury including
those of forex, credit, planning etc.
◦ Head of IT if a separate division exists
 UCBs may at their discretion may
have Sub-committees and Support
Groups
ALM Process
 Scope is
◦ Liquidity Risk Management
◦ Interest Rate Risk Management
◦ Trading (Price) risk Management
◦ Funding and Capital Management
◦ Profit Planning and business Projections
 ALM
•Liquidity Risk

•Interest Rate Risk

Liquidity Risk
 Arising due to
◦ Over extension of credit
◦ High level of NPAs
◦ Poor asset quality
◦ Mismanagement
◦ Non recognition of embedded option risk
◦ Reliance on few wholesale depositors
◦ Large undrawn loan commitments
◦ Lack of appropriate liquidity policy and
contingent plan
Liquidity vs. Earnings
 Bank must be in a position to:-
◦ Balance their need for liquidity with their
need for earnings
◦ More liquid assets tend to provide lower
return than do less liquid assets
Assessing Liquidity Position
 Assessing a bank’s liquidity position
can be challenging
 An adequate position for one bank
may not be sufficient for another
 A position considered adequate for a
bank in one time period may not be so
in another
 BANK SPECIFIC & DYNAMIC
Liquidity risk-Manifestation
 Funding risk
◦ Need to replace net outflows due to
unanticipated withdrawal/non-renewal of
deposits

 Time Risk
◦ Need to compensate for non-receipt of
expected inflows of funds-performing
assets turning into non-performing assets
Liquidity Risk - Measurement
 Two methods are employed:
◦ Stock approach - Employing ratios
◦ Flow approach - Time bucket analysis
Liquidity Risk - Measurement
 Liquidity Ratios
◦ Volatile Liability Dependence Ratio
 Volatile Liabilities minus Temporary Investments to Earning
Assets net of Temporary Investments
 Shows the extent to which bank’s reliance on volatile funds to
support Long Term assets
 where volatile liabilities represent wholesale deposits
which are market sensitive and temporary investments
are those maturing within one year and those
investments which are held in the trading book and are
readily sold in the market
◦ Growth in Core Deposits to growth in
assets
 Higher the ratio the better
Liquidity Risk – Measurement
(Contd.)

 Purchased Funds to Total Assets

◦ where purchased funds include the entire
inter-bank and other money market
borrowings, including Certificate of
Deposits and institutional deposits
 Loan Losses to Net Loans
 Loans to core deposits
Liquidity Risk – Measurement
(Contd.)

 Does not lead to proper assessment

of liquidity gaps due to:
◦ Illiquidity of liquid assets
◦ Their ready marketability
◦ Difficulty to convert easily into liquid cash with least loss of value
from the previously quoted market rates
Liquid Assets to Total Assets
 Liquid Assets to Total Assets
◦ Show the percentage of liquid assets in
the asset structure of the bank - 18-20%
 Liquid assets generally are cash
balances with RBI + balances with
other banks + investments available
for sale + money market instruments
Liquid Assets to Total
Deposits
 Liquid Assets to Total Deposits
◦ This ratio indicates extent of liquidity
maintained by a bank for meeting the
demand made by the depositors-
Sometimes taken as a measure of bank
liquidity-20-22%
Loans to Deposits
 Loans to Deposits
◦ Loans to deposits ratio indicates the
degree to which the bank has already
used up its available resources to
accommodate the credit needs of the
customers
◦ A high loan deposit ratio indicates that a
bank will have comparatively low liquidity
Loans to Assets
 Loans to Assets
◦ This ratio indicates the percentage of
illiquid assets to total assets
◦ A rise in this ratio would indicate lower
liquidity
Loans to Core Deposits
 Loans to Core Deposits
◦ Those deposits which are not subject to
any large volatility
◦ Average level of previous years deposit is
generally taken as core deposits
◦ This ratio helps in assessing level of
deployment of core portion of deposits
Loans to Investments
 Loans to Investments
◦ While loans provide higher returns
compared to investments, these suffer
from credit risk and are more illiquid than
investments
◦ A proper mix of loans and investments
keeping in view liquidity and yield
considerations need to be fixed
Cash Flow Approach
 Preparing a structural liquidity by taking into account balance
sheet on particular date and place in maturity ladder
according to time buckets
 Identify the liquidity needs - to evolve methods to meet it
 Negative gaps in individual time buckets indicate the need.
The need could be controlled by
◦ prudential limits
◦ as also by regulating the basis of business structure/financial
flexibility of banks
 Regulatory Limit of 20% on outflows in first two time buckets
RBI Guidelines on Liquidity
Risk
 Methodology prescribed in ALM System- Structural Liquidity
Statement & Dynamic Liquidity Ladder are simple
 Need to make assumptions and trend analysis- Behavioural
maturity analysis
 Variance Analysis at least once in six months and
assumptions fine-tuned
 Track the impact of exercise of options & potential liquidity
needs
 Cap on inter-bank borrowings & Call money
Trading Book
 Maintained distinctly from those
required for complying with Statutory
Reserve Requirements
 Subject to preconditions
◦ Composition and volume clearly defined
◦ Maximum maturity / Duration of the
portfolio restricted
◦ Holding period not exceeding 90 days
◦ Cut Loss prescribed
◦ Marked to market on a weekly basis
Dynamic Liquidity Gap
Analysis
 Tracking cash flow on a short term
time horizon- changes on account of
fresh business are interpolated in the
projections

 RBI has asked banks to monitor short

term liquidity on a dynamic basis over
time horizon spanning from 1-90 days
Short-Term Dynamic Liquidity Statement

 Main focus on short term mismatches

◦ 1-14days
◦ 15-28 days
◦ 29-90 days
 Dynamic Liquidity Analysis
(Amount Rs. Crore)

OUTFLOWS 1-90 days

Net increase in loans and advances 950

Net increase in investments 275

TOTAL OUTFLOWS 1225

INFLOWS

Net cash position 50

Net increase in deposits(less CRR) 619

Refinance 60

Total Inflows 729

Mismatch(Inflows-Outflows) (-)496

Mismatch as a % of Total Outflows (-)40.49%

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
RSA and RSL
 Rate Sensitive Assets (RSA) – Assets
whose value is dependent on current
interest rate
 Risk Sensitive Liabilities (RSL) –
Liabilities whose value is dependent
on current interest rate
Gap / Mismatch Risk
 Arises on account of holding RSA and
RSL with different principal amounts,
maturity / repricing rates
 Even though maturity dates are same,
if there is a mismatch between amount
of assets and liabilities it causes
interest rate risk and affects NIM
Interest Rate Risk
 Assessed by Gap Report – Gaps
between RSA and RSL
 Asset / Liabilities are rate sensitive if:
◦ Within the time interval under
consideration there is a Cash Flow
 Repayment of term loans
◦ Interest rate resets / reprices
 Change in interest rate in CC account, Term Loans before
maturity
◦ RBI changes interest rates
 Interest on Savings Bank Deposits, CRR balance etc.
Interest Rate Risk (contd.)

 Assessed by Gap Report – Gaps

between RSA and RSL
 Gaps may be identified in the following
time bands:
◦ Upto 3 months
◦ Over 3 months and upto 6 months
◦ Over 6 months and upto 1 year
◦ Over 1 year and upto 3 years
◦ Over 3 years and upto 5 years
◦ Over 5 years
◦ Non-sensitive
Interest Rate Risk (contd.)

 Immediate impact of changes is on

bank’s profit by change in its spread –
NII
◦ NII gives the earning perspective
 Long term impact is change in its MVE
or Net Worth
◦ As marked to market value of bank’s
asset – liabilities, off-balance sheet
positions get affected
◦ Gives the economic value perspective
 Credit Risk
 Credit risk refers to the probability of
loss due to a borrower’s failure to
make payments on any type of debt.
 Credit risk management is the practice
of mitigating losses by understanding
the adequacy of a bank’s capital and
loan loss reserves at any given time –
a process that has long been a
challenge for financial institutions
Credit risk process & credit risk
management

Allocate Set objectives

provisions; and
capital responsibilitie
charges s
Monitor
credit Set credit
performance risk
guidelines

Make
credit Collect
decisions credit data
Measure
and assess
credit risk
Important factors for credit
approval
Current risk profile (incl. the nature and aggregate amounts
of risks) of the borrower or counterparty and its sensitivity to
economic and market developments;
Borrower’s repayment history and current capacity to
repay, based on the historical trends in its financials and
future cash flow projections, under various scenarios;
customer’s capacity to increase its level of indebtedness;
The proposed terms and conditions of the credit,
including covenants designed to limit changes in the future
risk profile of the borrower;
Proposed collateral types, LTV, adequacy and
enforceability of collaterals or guarantees, under various
scenarios;
Integrity and reputation of the borrower or counterparty.
Credit risk assessment tools
Expert judgment
Based on assessment of factors like: the features of the
credit facility, the capital position (incl. capital structure)
of the applicant, its repayment capacity, the
collateralization, the economic conditions and the
business cycle on the respective market
Credit rating systems
Capture all relevant information about the borrower and
assign a grade through a risk rating process, by the
consideration of financial and non-financial factors
Limits system
Prudential regulations for single borrowers/related
parties, risk class/rating linked exposures, industry level
caps, delegation of powers
If the likelihood of discharging an
obligation is 94.6%. The recovery rate is
90%. The exposure at default is Rs. 3
crore

What can be the expected loss of the

bank?
 Market Risk
 The possibility of a loss to the bank
caused by changes in market
variables

 Risk to Bank’s earnings due to

changes in the market level of interest
rates or price of securities, Foreign
Exchange, Commodities & Equities as
well as volatilities in the prices
FOREIGN EXCHANGE RISK
• Risk that Bank may suffer loss as
result of adverse exchange rate
movements during the period in which it
has open position.
• Risk arises whenever business has
income/expenditure, asset/liability in a
currency other than
balance sheet currency
FOREX RISK
MANAGEMENT
1.Set appropriate limit for open
position/gaps.
2. Clear cut & well defined division of
responsibility between front, middle &
back office.
3. Use of hedging tools like forwards,
futures & options.
 EQUITY PRICE RISK
• Changes in Equity prices can result
losses to the bank holding Equity
portfolio.
• Banks are not allowed to sell the
securities with out holding the same.
• Banks are free to acquire shares
/Debs/Units of equity oriented mutual
funds subject to ceiling of 5% of the
total domestic credit
Equity Price Risk -
Management
1. Build up adequate exposure to
equity market
2. Formulate transparent policy &
procedure for investment in shares.
3. Formation of Investment committee.
4. Review of Investment portfolio – on
going basis.
5. Fixing prudential exposure limits.
 COMMODITY PRICE RISK
 Banks have very little exposure to
commodities in their trading book.
 Price rise/movement in commodities is
more complex & volatile.
 Banks in developed countries use
derivatives to hedge commodity price
risk.