Ch 9 - ALM in Banks

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Asset – Liability Management in Banks:

Asset – Liability Management in Banks By : Gaurang Badheka MFIS, Sem - 3

What is ALM?:

DEFINITION ALM is continuously arranging and rearranging the assets and liabilities of the bank without infringing the liquidity and safety of the bank and with the purpose of maximizing the bank’s profits. What is ALM?

Liquidity & Safety:

The ability of a bank to fulfill its obligations, and after doing so having enough cash left to do its normal daily banking business. The ability of a bank’s “Share Holder’s Equity” (SHI) to absorb the future possible losses that may arise and after doing so having enough SHI left to run the bank and to comply with the minimum “Capital Requirements”. Liquidity & Safety

Basics of ALM :

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-management functions in bank is Asset Liability Management. interest rates were used to price the assets and liabilities of banks. However, in the deregulated environment, competition has narrowed the spreads of banks. Basics of ALM

Basics of ALM:

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. Basics of ALM

Basics of ALM:

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. Basics of ALM

Basics of ALM:

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. Basics of ALM

ALM development:

ALM development 1950’s 1960’s 1970’s Asset Management Liability Management Asset and Liability Management Loan Products Deposit Products Loan and Deposit Products

Bank Balance Sheet:

Bank Balance Sheet Liabilities Assets Capital Reserve & Surplus Deposits Borrowings Other Liabilities Cash & Balances with RBI Bal. With Banks & Money at Call and Short Notices Investments Advances Fixed Assets 6. Other Assets

Components of Liabilities:

Capital: Capital represents owner’s contribution / stake in the bank. It serves as a cushion for depositors and creditors. It is considered to be a long term sources for the bank. Components of Liabilities

Components of liabilities:

2. Reserves & Surplus I. Statutory Reserves II. Capital Reserves III. Investment Fluctuation Reserve IV. Revenue and Other Reserves V. Balance in Profit and Loss Account Components of liabilities

Components of Liabilities:

3. Deposits This is the main source of bank’s funds. The deposits are classified as deposits payable on ‘demand’ and ‘time’. They are reflected in balance sheet as under: I. Demand Deposits II. Savings Bank Deposits III. Term Deposits Components of Liabilities

Components of Liabilities:

4. Borrowings (Borrowings include Refinance/Borrowings from RBI, Inter-bank & other institutions) I. Borrowings in India i ) Reserve Bank of India ii) Other Banks iii) Other Institutions & Agencies II. Borrowings outside India Components of Liabilities

Components of Liabilities :

5. Other Liabilities & Provisions I. Bills Payable II. Inter Office Adjustments (Net) III. Interest Accrued IV. Unsecured Redeemable Bonds (Subordinated Debt for Tier-II Capital) V. Others (including provisions) Components of Liabilities

Components of Assets:

Cash & Bank Balances with RBI I. Cash in hand (including foreign currency notes) II. Balances with Reserve Bank of India In Current Accounts In Other Accounts Components of Assets

Components of Assets:

2. BALANCES WITH BANKS AND MONEY AT CALL & SHORT NOTICE I. In India i ) Balances with Banks a) In Current Accounts b) In Other Deposit Accounts ii) Money at Call and Short Notice a) With Banks b) With Other Institutions II. Outside India a) In Current Accounts b) In Other Deposit Accounts c) Money at Call & Short Notice Components of Assets

Components of Assets:

3. Investments A major asset item in the bank’s balance sheet. Reflected under 6 buckets as under: I. Investments in India in : i ) Government Securities ii) Other approved Securities iii) Shares iv) Debentures and Bonds v) Subsidiaries and Sponsored Institutions vi) Others (UTI Shares , Commercial Papers, COD & Mutual Fund Units) II. Investments outside India in Subsidiaries and/or Associates abroad Components of Assets

Components of Assets:

4. Advances The most important assets for a bank. A. i ) Bills Purchased and Discounted ii) Cash Credits, Overdrafts & Loans repayable on demand iii) Term Loans B. Particulars of Advances : i ) Secured by tangible assets (including advances against Book Debts) ii) Covered by Bank/ Government Guarantees iii) Unsecured Components of Assets

Components of Assets:

5. Fixed Asset I. Premises II. Other Fixed Assets (Including furniture and fixtures) 6. Other Assets I. Interest accrued II. Tax paid in advance/tax deducted at source (Net of Provisions) III. Stationery and Stamps IV. Non-banking assets acquired in satisfaction of claims V. Deferred Tax Asset (Net) VI. Others Components of Assets

Purpose and objective of ALM:

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 ration. 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) Purpose and objective of ALM

Liquidity management :

Bank’s liquidity management is the process of generating funds to meet contractual or relationship obligations at reasonable prices at all times. New loan demands, existing commitments and deposit withdrawals are the basic contractual or relationship obligations that a bank must meet. Liquidity management

Liquidity position:

Analysis of following factors throw light on a bank’s adequacy of liquidity position: Historical Funding requirement Current liquidity position Anticipated future funding needs Sources of funds Options for reducing funding needs Present and anticipated asset quality Present and future earning capacity and h. Present and planned capital position Liquidity position

Liquidity risk :

Arising due to Over extension of credit High level of NPAs Poor asset quality Mismanagement Hot Money Non recognition of embedded option risk Reliance on few wholesale depositors Large undrawn loan commitments Lack of appropriate liquidity policy and contingent plan Liquidity risk

Funding avenues :

To satisfy funding needs, a bank must perform one or a combination of the following: Dispose off liquid assets Increase short term borrowings Decrease holding of less liquid assets Increase liability of a term nature e. Increase Capital funds Funding avenues

Statement of liquidity :

1 to 14 days 15 to 28 days 29 days and up to 3 months Over 3 months and up to 6 months Over 6 months and up to 1 year Over 1 year and up to 3 years Over 3 years and up to 5 years Over 5 years Statement of liquidity

Example of structural liquidity:

Example of structural liquidity

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 Problem of mismatch

Problem of mismatch:

Interest Rate Risk  Affects profitability Liquidity Risk  May lead to liquidation General Strategy Eliminate Liquidity Risk (not the mismatch) Manage Interest Rate Risk Problem of mismatch

Addressing the mismatch:

Mismatches can be positive or negative Positive Mismatch: M.A.>M.L. ;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. Addressing the mismatch

Success of ALM in banking :

Awareness for ALM in the Bank staff at all levels–supportive Management & dedicated Teams. Method of reporting data from Branches/ other Departments. (Strong MIS). Full computerization, networking. Insight into the banking operations, economic forecasting, computerization, investment, credit. 5. Linking up ALM to future Risk Management Strategies. Success of ALM in banking

ALM Pillars:

ALM Information Systems ALM Organisation ALM Process ALM Pillars

ALM Pillars:

ALM Information systems MIS Information availability Accuracy Adequacy Expediency ALM Organisation Structure and responsibilities Level of top management involvement ALM Pillars

ALM Pillars:

ALM Process Risk Parameters Risk Identification Risk Measurement Risk Management Risk Policies and Procedures, prudential limits and auditing, reporting and review ALM Pillars

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

Interest rate risk :

Interest rate risk refers to volatility in Net Interest Income (NII) or variations in Net Interest Margin (NIM). Therefore, an effective risk management process that maintains interest rate risk within prudent levels is essential to safety and soundness of the bank. Interest rate risk

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 RSA and RSL

RSA and RSL – Mismatch / Gap:

Arises on account of holding RSA and RSL with different principal amounts, maturity / re-pricing 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 RSA and RSL – Mismatch / Gap

Measuring interest rate risk:

Gap Analysis - Simple maturity/re-pricing Schedules can be used to generate simple indicators of interest rate risk sensitivity of both earnings and economic value to changing interest rates. - If a negative gap occurs (RSA<RSL) in given time band, an increase in market interest rates could cause a decline in NII. - conversely, a positive gap (RSA>RSL) in a given time band, an decrease in market interest rates could cause a decline in NII. Measuring interest rate risk

Measuring interest rate risk:

Duration Analysis: Duration is a measure of the percentage change in the economic value of a position that occur given a small change in level of interest rate. Measuring interest rate risk

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