Asset liability management

Asset Liability Management
Submitted by,
Firoze p
2nd MBA
Department of Management Studies
Pondicherry University

Assets Liability Management
It is a dynamic process of Planning,
Organizing & Controlling of Assets &
Liabilities- their volumes, mixes, maturities,
yields and costs in order to maintain liquidity
and NII.
Equities Liabilities Assets

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.

Objectives
O
B
J
E C T I
V
E
S
Liquidity Risk
Management
Interest Rate
Risk
Management
Currency Rate Risk
Management
Profit Planning
Growth
Projection
Balancing
A & L

Need
Risk
Tolerance
Shareholders
Expectations
Regulatory
Requirements
Accounting
Requirements
Investment
Market
Other
stakeholders
Interest
O
B
J
E C T I
V
E
S
C
O
M P A
N
Y

3 Pillars of ALMInformationSystem
Organisation
Process

ALM Information Systems
 Usage of Real Time information system to gather the
information about the maturity and behaviour 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/speed of computerisation will 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 Process
Risk Parameters
Risk Identification
Risk Measurement
Risk Management
Risk Policies and Tolerance Level

Definition :
Liquidity risk refers to the risk that the institution might not be
able to generate sufficient cash flow to meet its financial
obligations
Liquidity Risk
Effects
 Risk to bank’s earnings
 Reputational risk
 Contagion effect
 Liquidity crisis can lead to runs on Banks & their failures can
affect Global economies

Funding risk
Arises due to unanticipated
withdrawals of the deposits
from wholesale or retail
clients
Time risk
It arises when an asset
turns into a NPA. So, the
expected cash flows are no
longer available to the
bank.
Call Risk
Due to crystallisation of
contingent liabilities and
unable to undertake
profitable business
opportunities when
available.
Liquidity risk arises from funding of long term assets by short term
liabilities, thus making the liabilities subject to refinancing

Factors affecting Liquidity Risk
 over extension of credit
 High level of NPAs
 Poor AML Policy
 Poor asset quality
 Mismanagement Reliance on a few
wholesale depositors
 Large undrawn loan commitments
 Lack of appropriate liquidity policy & contingent
plan

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.

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.

Interest Rate Risk
 Interest Rate risk is the exposure of a bank’s financial conditions to
adverse movements of interest rates which 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)
Therefore, an effective risk management process that maintains
interest rate risk within prudent levels is essential to safety and
soundness of the bank.

Sources of Interest Rate Risk
Interest
Rate
Risk
Basis
Re-pricing
Yield
Options

Re-pricing Risk
The assets and liabilities could re-
price at different dates and might be
of different time period. For example,
a loan on the asset side could re-price
at three-monthly intervals whereas
the deposit could be at a fixed
interest rate or a variable rate, but re-
pricing half-yearly
Basis Risk
The assets could be based on
LIBOR rates whereas the
liabilities could be based on
Treasury rates or a Swap
market rate

Yield Curve Risk
The changes are not always
parallel but it could be a twist
around a particular tenor and
thereby affecting different
maturities differently
Option Risk
Exercise of options impacts the
financial institutions by giving rise
to premature release of funds that
have to be deployed in unfavourable
market conditions and loss of profit
on account of foreclosure of loans
that earned a good spread.

Risk Measurement Techniques
Simulation

Maturity gap method
THREE OPTIONS:
• A) Rate Sensitive Assets > Rate Sensitive Liabilities=
Positive Gap
• B) Rate Sensitive Assets < Rate Sensitive Liabilities =
Negative Gap
• C) Rate Sensitive Assets = Rate Sensitive Liabilities =
Zero Gap

• It basically refers to the average life of the asset or the liability
• It is the weighted average time to maturity of all the preset
values of cash flows
• The larger the value of the duration, the more sensitive is the
price of that asset or liability to changes in interest rates
• As per the above equation, the bank will be immunized from
interest rate risk if the duration gap between assets and the
liabilities is zero.
Duration Analysis

Simulation
• Basically simulation models utilize computer power to provide
what if scenarios, for example: What if:
– The absolute level of interest rates shift
– Marketing plans are under-or-over achieved
– Margins achieved in the past are not sustained/improved
– Bad debt and prepayment levels change in different
interest rate scenarios
– There are changes in the funding mix e.g.: an increasing
reliance on short-term funds for balance sheet growth
• This dynamic capability adds value to this method and
improves the quality of information available to the
management

Value at Risk
• Refers to the maximum expected loss that a bank can suffer in
market value or income:
– Over a given time horizon,
– Under normal market conditions,
– At a given level or certainty
• It enables the calculation of market risk of a portfolio for
which no historical data exists. VaR serves as Information
Reporting to stakeholders
• It enables one to calculate the net worth of the organization
at any particular point of time so that it is possible to focus on
long-term risk implications of decisions that have already
been taken or that are going to be taken

Asset and liability
management committee
(ALCO)

ALCO - Role & Responsibilities
 ALCO decision making unit- Responsible for balance sheet planning from risk
return perspective
 Monitoring the market risk levels by ensuring adherence to the various risk
limits set by the bank
 Articulating the current interest rate view and a view on future direction of
interest rate movements
 Deciding the business strategy of the bank, consistent with the interest rate
view, budget and pre-determined risk management objective.
 Determining the desired maturity profile and mix of assets and liabilities
 Product pricing for both assets and liabilities side
 Deciding the funding strategy i.e. source and mix of liabilities or sale of assets
 Reviewing implementation of decisions made in the previous meeting

Asset liability management

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Asset liability management