AN ASSIGNMEMT

ON

ASSETS – LIABILITIES MANAGEMENT

PROPRIETORY IN BANKS

SUBMITTED BY SHAH PRIYANK (47)

SUBMITTED TOPROF. KAUMADI UPADHYAY

ACADEMIC YEAR2007-09

SUBMITTED TOS.V. INSTITUTE OF MANAGEMENT, KADI

AFFILIATED TOHEMCHANDRACHARYA NORTH GUJARAT UNIVERSITY

PATAN

INTRODUCTION

“If there is any area of banking that has undergone drastic change, it is the whole subject of assets/liabilities management.” - Paul S. Nadler

“Strong capital will not guarantee liquidity in all circumstances. There can be panics and sudden increase in the demand for liquidity. It is the job of the central banks to help in those circumstances. But a strong capital base in the system and in all its components is likely to limit future liquidity shocks. - Jean Pierre Landau, Deputy Governor, Bank of France

Liquidity management is a provoking idea for the management of the financial institutions to ponder about and act. But how to act and when to act are the questions which lead to Assets and Liability Management (ALM), a management tool to monitor and manage various aspects of risks associated with the balance sheet management , including the management and balance sheet exposure of the institutions. In other words, “ALM is an ongoing process of formulating, monitoring, revising and framing strategies related to assets and liabilities in an attempt to achieve the financial objective of maximizing interest spread or margins for a given set of risk level.” It is not only a liquidity management tool, but also a portfolio management tool to alter the composition of assets and liability portfolio to manage the risk by using various risk mitigating measures.

Assets/liability management is an integral part of the planning process of commercial banks. In fact, asset/liability management may be considered as one of the three principal components of a planning system. The three components are:

Asset/liability management which focuses primarily on the day-to-day or week-to-week balance sheet management necessary to achieve short term financial goals. Annual profit planning and controls which focus on slightly longer term goals and look at a detailed financial plan over the course of a fiscal or calendar year. Strategic planning which focuses on the long run financial and non financial aspects of a bank’s performance.

CONCEPT OF ALM

ALM is a system of matching cash inflows and outflows in the system, and is thus a management tool of liquidity management. Hence, if a bank meets its Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) stipulation regularly without undue and frequent resort to purchased / borrowed funds and without defaults, it can be said to have a satisfactory system of managing liquidity risks and so, of ALM. The spread between the deposit and lending rates were wide and also were more or less uniform and changed only at the instance of the RBI. Clearly, the institutions, themselves were not managing the balance sheet; it was being ‘managed’ and controlled through prescriptions of the regulatory authority and the government. Ever since the initiation of the process of deregulation and liberation of interest rates and consequent injection of a dose of competition, the need for ALM was felt. With deregulation of interest rates and greater freedom being given to the organizations to decide and mange the cost of lending and borrowing and ultimately management of the balance sheet. Hence, the need for a system such as ALM, which could provide the necessary framework to define, measure, monitor, modify and manage the interest risk.

Asset/liability management focuses on the net interest income if the institutions. Net interest income is the difference between the amount of interest received from loans and investments and the amount of interest paid for deposits and other liabilities.

Net interest income = interest revenue – interest expense

Expressing the net interest income as a percentage of earning allows us to express the interest income as a margin. The total net interest income may not be meaningfully compared between banks of different size but the margin may be meaningfully compared.

Net interest margin = Net interest income / earning assets

HISTORICAL PERSPECTIVE

The ALM, historically, has evolved from the early practice of managing liquidity on the bank’s asset side, to a later shift to the liability side and termed liability management, to a still later realization of using both the assets as well as the liabilities side of the balance sheet to achieve optimum resources management, i.e., an integrated approach. Prior to deregulation, bank funds were obtained from relatively stable demand deposits and from small time deposits. Interest rate ceiling limited the extent to which banks could compete for funds. Opening more branches in order to attract fresh deposits. As a result, most sources of funds were core deposits which were quite impervious to interest rate movements in this environment bank fund management concentrate on the control of assets. The bank’s ability to grow will be hampered if they do not have access to the funds required to create assets. They have freedom to obtain funds by borrowing from both the domestic and international markets. As they tap different source of funds, there is an increased need for liability management and it becomes an important part of their financial management.

With liability management, banks now have two sources of funds – core deposits and purchased funds – with quite different characteristics. For core deposits, the volume of funds is relatively insensitive to changes in interest rate levels. From the perspective of the management, the core deposits offer the advantage of stability. However core deposits have the disadvantage of not being overly responsive to management needs for expansion. If a bank experiences a sizeable increase in loan demand, it can not expect the core deposits to increase proportionately. For purchased funds, however, the bank can obtain all the funds that it wants if it is willing to pay the market determined price. Unlike core deposits where the bank determines the price, the interest rates on purchased funds are set in the national money market. The bank can be thought of as a price taker in the purchased funds market whereas in the core deposit market it can be viewed as a price setter. The purchased funds give complete flexibility in terms of the volumes and timing of the availability of funds.

MODERN PERSPECTIVE

The recent volatility of interest rates broadened to include the issue of credit risk and market risk and to ensure that their risk management capabilities are commensurate with the risk of their business. The induction of credit risk into the issue of determining adequacy of bank capital further enlarged the scope of ALM. According to policy approach of Basel II in India, to conform to best international standards and in the process emphasis is on harmonization with the international best practices. If this were so, the scope and the role of ALM becomes all the more enlarged. Incidentally, commercial banks in India will start implementing Basel II with effect from March 31, 2008 though, as indicated by the governor of the RBI, a marginal stretching beyond this date can not be ruled out in view of latest indications of the state of preparedness.

In current spell, earning a proper return for the promoter of equity and maximization of its market value means management of the balance sheet of the institution. In other words, this also implies that managements are now expected to target required profit levels and ensure minimization of risks to acceptable levels, to retain the interest of the investing community. In today’s competitive environment, if the organization has to remain in the business, costing and product pricing policies have to be suitably structured. Thus, with the changing requirement, there is a need for not only managing the net interest margin of the organization but at the same time ensuring that liquidity is managed, how much liquid the organization has to be definitely, worked out on the basis of scenario analysis, but the knowledge to management, adopt the new system and organizational changes that are called for it to manage, have to be defined. Thus, the concept of ALM is much wider and is of greater significance.

The ALM process rests on three pillars:

· ALM information systems=> Management Information System=> Information availability, accuracy, adequacy and expediency·

ALM organisation=> Structure and responsibilities=> Level of top management involvement·

ALM process=> Risk parameters=> Risk identification=> Risk measurement=> Risk management=> Risk policies and tolerance level

ALM information systems

Information is the key to the ALM process. Considering the large network of branches and the lack of an adequate system to collect information required for ALM which analyses information on the basis of residual maturity and behavioural pattern it will take time for banks in the present state to get the requisite information. The problem of ALM needs to be addressed by following anABC approach i.e. analysing the behaviour of asset and liability products in the top branches accounting for significant business and then making rational assumptions about the way in which assets and liabilities would behave in other branches. In respect of foreign exchange, investment portfolio and money market operations, in view of the centralised nature of the functions, it would be much easier to collect reliable information. The data and assumptions can then be refined over time as the bank management gain experience of conducting business within an ALM framework. The spread of computerisation will also help banks in accessing data.

ALM organization

a) The Board should have overall responsibility for management of risks and should decide the risk management policy of the bank and set limits for liquidity, interest rate, foreign exchange and equity price risks.

b) The Asset - Liability Committee (ALCO) consisting of the bank's senior management including CEO should be responsible for ensuring adherence to the limits set by the Board as well as for deciding the business strategy of the bank (on the assets and liabilities sides) in line with the bank's budget and decided risk management objectives.

b) The ALM desk consisting of operating staff should be responsible for analysing, monitoring and reporting the risk profiles to the ALCO. The staff should also prepare forecasts (simulations) showing the effects of various possible changes in market conditions related to the balance sheet and recommend the action needed to adhere to bank's internal limits.

The ALCO is a decision making unit responsible for balance sheet planning from risk - return perspective including the strategic management of interest rate and liquidity risks. Each bank will have to decide on the role of its ALCO , its responsibility as also the decisions to be taken by it. The business and risk management strategy of the bank should ensure that the bank operates within the limits / parameters set by the Board. The business issues that an ALCO would consider, inter alia, will include product pricing for both deposits and advances, desired maturity profile of the incremental assets and liabilities, etc. In addition to monitoring the risk levels of the bank, the ALCO should review the results of and progress in implementation of the decisions made in the previous

meetings. The ALCO would also articulate the current interest rate view of the bank and base its decisions for future business strategy on this view. In respect of the funding policy, for instance, its responsibility would be to decide on source and mix of liabilities or sale of assets. Towards this end, 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, etc. Individual banks will have to decide the frequency for holding their ALCO meetings.

Composition of ALCOThe size (number of members) of ALCO would depend on the size of each institution, business mix and organisational complexity. To ensure commitment of the Top Management, the CEO/CMD or ED should head the Committee. The Chiefs of Investment, Credit, Funds Management / Treasury (forex and domestic), International Banking and Economic Research can be members of the Committee. In addition the Head of the Information Technology Division should also be an invitee for building up of MIS and related computerisation. Some banks may even have sub-committees.

Committee of DirectorsBanks should also constitute a professional Managerial and Supervisory Committee consisting of three to four directors which will oversee the implementation of the system and review its functioning periodically.

ALM process:The scope of ALM function can be described as follows: Liquidity risk management Management of market risks(including Interest Rate Risk) Funding and capital planning Profit planning and growth projection Trading risk managementThe guidelines given in this note mainly address Liquidity and Interest Rate risks.

Credit risk management

Credit risk management plays a vital role in the way banks perform. It reflects

- The profitability - Liquidity - Reduced NPAs.

Credit risk management is a process that puts in place systems and procedures enabling a bank to-

- Identify & measure the risk involved in a credit proposition, both at the individual transaction and portfolio level.

- Evaluate the impact of exposure on bank’s financial statements.- Assess the capability of risk mitigates to hedge/ insure risks.- Design an appropriate risk management strategy to arrest “risk- migration”.

Way for Credit Risk Management:-

Credit risk management is done at two levels-Micro level & Macro level.As the credit risk management at micro-level is focused on clients, the efficiency level of the operating staff in credit evaluation and monitoring needs to be honed up.

In macro level approach to credit risk management, the Capital Adequacy Ratio (CAR) plays a crucial role. The bank management stipulates the industry exposures keeping the overall position of its credit deployment.

Risk transfer is a popular risk management technique being used today. The development of credit derivatives is a logical extension of two of the most significant developments such as securitization and derivatives. A credit asset is a bundle of risks and returns. And every asset is acquired to make certain returns. However, the probability of not making the expected return is the default risk associated with every credit asset. One of the alternatives available to a bank in managing credit risk is the use of credit derivatives. Credit derivatives facilitate risk transfer. This concept has picked up momentum in the US and European markets and is yet to pick up in India. Considering the pathetic scenario of loan portfolio in Indian banks, our regulators can explore the possibilities of developing instruments facilitating credit risk transfer.

MEASURING INTEREST RATE SENSITIVITY

The most commonly used measure of the interest rate position of a bank is Gap analysis. The Gap is the difference between the amount of the rate sensitive assets and rate sensitive liabilities. The Gap may be expressed in a variety of ways. The simplest is the rupee Gap – the difference between the amounts of RSA and RSL expressed in rupees. Some other measures of Gap are the relative Gap ratio, which is the ratio of the rupee Gap and the Total assets. Another measure is the interest rate sensitivity ratio, which is the ratio of the RSA to RSL.

Relative Gap ratio = Rupee Gap / Total assetsInterest rate sensitivity ratio = RSA / RSL

A bank at a given time may be asset or liability sensitive. If the bank were asset sensitive, it would have a positive Gap, appositive relative Gap ratio and an interest sensitivity ratio greater than one. Conversely, a bank that is liability sensitive would have a negative Gap, a negative relative Gap ratio and interest sensitivity ratio less than one. Banks that are asset sensitive experience an increase in their net interest income when interest rate increase and vice – versa. Conversely, banks that are liability sensitive see their net interest income decrease when interest rate and vice – versa. The below table summarises the effects interest rate changes on net interest income for different Gap positions.

Effects of Changes in Interest Rates

The focus of asset/liability management is on interest rate risk. However, a management is concerned with managing the entire risk profile of the institutions, including interest risk, credit risk, liquidity risk and other dimensions of risk. If those risk were unrelated, then managers could concentrate on one type of risk, making appropriate decisions and ignoring the effect of the decisions on the other types of risks. However, the different types of risks have a high degree of correlation, especially the interest rate risk and the credit risk.

Gap Changes in Interest Rate

Changes in Net Interest Rate

Positive Increase IncreasePositive Decrease DecreaseNegative Increase DecreaseNegative Decrease IncreaseZero Increase ZeroZero Decrease Zero

CLASSIFICATION OF ASSETS AND LIABILITIES

ASSETS CLASSIFICATION LIABILITIES AND CAPITAL

CLASSFICATION

Vault cash NRSA Demand deposits

NRSL

Short term securities RSA Current accounts NRSLLong term securities NRSA Money market

depositsRSL

Variable rate loansRSA

Short term deposits

RSL

Short term loans RSA Long term saving NRSLLong term loans NRSA Repo transaction RSLOther assets NRSA Equity NRS

The above table shows the classification of the assets and liabilities of a bank according to their interest rate sensitivity. Those assets and liabilities whose interest return or costs vary with interest rate changes over some time horizon are referred to as Rate Sensitive Assets(RSA) or Rate Sensitive Liabilities(RSL). Those assets or liabilities whose interest return or costs do not vary with interest rate movements over the same time horizon are referred to as Non – rate Sensitive Assets (NRSA) or Non – rate Sensitive Liabilities (NRSL). It is very important to note that the critical factor in the classification is the time horizon chosen. An asset or liability that is time sensitive in a certain time horizon may not be sensitive in a shorter time horizon and vice – versa. However, over a sufficiently long time horizon, virtually all assets and liabilities are interest rate sensitive. As the time horizon is shortened, the ratio of rate sensitive to non rate sensitive assets and liabilities falls. At some sufficiently short horizon, say one day, virtually all assets and liabilities are non interest rate sensitive.

Liquidity Risk Management

Measuring and managing liquidity needs are vital activities of commercial banks. By assuring a bank's ability to meet its liabilities as they become due, liquidity management can reduce the probability of an adverse situation developing. The importance of liquidity transcends individual institutions, as liquidity shortfall in one institution can have repercussions (indirect effect) on the entire system. Bank management should measure not only the liquidity positions of banks on an ongoing basis but also examine how liquidity requirements are likely to evolve under crisis scenarios. Experience shows that assets Commonly considered as liquid like Government securities and other money market instruments could also become illiquid when the market and players are unidirectional. Therefore liquidity has to be tracked through maturity or cash flow mismatches. For measuring and managing net funding requirements, the use of a maturity ladder and calculation of cumulative surplus or deficit of funds at selected maturity dates is adopted as a standard tool.

The Maturity Profile could be used for measuring the future cash flows of banks in different time buckets. The time buckets given the Statutory Reserve cycle of 14 days may be distributed as under:

i) 1 to 14 daysii) 15 to 28 daysiii) 29 days and upto 3 monthsiv) Over 3 months and upto 6 monthsv) Over 6 months and upto 12 monthsvi) Over 1 year and upto 2 yearsvii) Over 2 years and upto 5 yearsviii) Over 5 years

LIQUIDITY MANAGEMENT IN FINANCIAL INSTITUTIONS

As mentioned earlier, “Strong capital will not guarantee liquidity in all circumstances. There can be panics and sudden increases in the demand for liquidity.” How regulatory authorities view liquidity concerns and how they meet the requirement of the institutions can be better understood from the statement by Reserve Bank of India Governor, which states, “liquidity management is carried out through Open Market Operation (OMO) in the form of out right purchase / sales of government securities and reverse repo / repo operations, supplemented by the newly introduced Market Stabilization Schemes(MSS). The Liquidity Adjustment Facility (LAF), introduced in June 2000, enables the RBI to modulate short term liquidity, of a temporary nature, under varied financial market conditions in order to ensure stable conditions in the overnight (call) money market.” In addition to above requirement met by the regulatory authorities i.e., the RBI, financial institutions manage their liquidity concern in many ways by employing various available tools such as:

Liquid AssetsDifferent regulatory authorities in different parts of the world have prescribed financial institutions to maintain certain percentage of liquid assets to their liabilities. For instance, the central bank of Solomn Islands requires financial institutions to maintain a minimum liquid assets of 7% of liabilities. Similarly, the RBI has prescribed CRR and SLR . Composition of the same could vary with the requirements.

By Setting a Limit on Maturity MismatchesFinancial institutions could also monitor and control the gaps between maturing assets and liabilities in various time buckets. The maturity profile should take into account the off – balance sheet exposure and its cash flows. The construction of such maturity profile relies heavily on assumptions that certain proportion of maturing liabilities will be able to rollover, by the financial institutions. Short term maturity gaps in the shorter time periods, say 1 to 7 days bucket. Various regulatory agencies have prescribed limits and control measures to monitor this aspect.

A Diversified Source for Liability RaisingAs part of overall liquidity management, institution should seek to maintain a well diversified funding base and at the same time understand that frequently approaching markets on such borrowed funds could be costly affair. The market also responds very adversely so such frequent approaches and regulatory agencies have been cautioning against this practice of dependence on such short term sources.

By Availing Funds from the Wholesale MarketsThe ability to raise funds in the inter- bank market or other wholesale markets can be an important source of liquidity but this may be substantially reduced or delayed in a crisis conditions. Financial institutions could estimate their requirement liquidity and lay down board approved policies in this regard.

To Have Boards – approved Contingency PlanA well though out plan approved by the board could include procedure for dealing with major liquidity problems, suggestions for corrective course of action and details for dealing with public and media personnel, etc.

Currency Risk Management

Floating exchange rate arrangement has brought in its wake pronounced volatility adding a new dimension to the risk profile of banks' balance sheets. The increased capital flows across free economies following deregulation have contributed to increase in the volume of transactions. Large cross border flows together with the volatility has rendered the banks' balance sheets vulnerable to exchange rate movements.

Dealing in different currencies brings opportunities as also risks. If the liabilities in one currency exceed the level of assets in the same currency, then the currency mismatch can add value or erode value depending upon the currency movements. The simplest way to avoid currency risk is to ensure that mismatches, if any, are reduced to zero or near zero. Banks undertake operations in foreign exchange like accepting deposits, making loans and advances and quoting prices for foreign exchange transactions. Irrespective of the strategies adopted, it may not be possible to eliminate currency mismatches altogether. Besides, some of the institutions may take proprietary trading positions as a conscious business strategy.

Managing Currency Risk is one more dimension of Asset- Liability Management.Presently, the banks are also free to set gap limits with RBI's approval but are required to adopt Value at Risk (VaR) approach to measure the risk associated with forward exposures. Thus the open position limits together with the gap limits form the risk management approach to forex operations.

HYPOTHETICAL EXAMPLE OF MISMATCH BETWEEN ASSETS AND LIABILITIES

Consider a bank that borrows USD 100MM at 3.00% for a year and lends the same money at 3.20% to a highly-rated borrower for 5 years. For simplicity, assume interest rates are annually compounded and all interest accumulates to the maturity of the respective obligations. The net transaction appears profitable—the bank is earning a 20 basis point spread—but it entails considerable risk. At the end of a year, the bank will have to find new financing for the loan, which will have 4 more years before it matures. If interest rates have risen, the bank may have to pay a higher rate of interest on the new financing than the fixed 3.20 it is earning on its loan.

Suppose, at the end of a year, an applicable 4-year interest rate is 6.00%. The bank is in serious trouble. It is going to be earning 3.20% on its loan and paying 6.00% on its financing. Accrual accounting does not recognize the problem. The book value of the loan (the bank's asset) is:

100MM(1.032) = 103.2MM

The book value of the financing (the bank's liability) is:

100MM(1.030) = 103.0MM

Based upon accrual accounting, the bank earned USD 200,000 in the first year.

Market value accounting recognizes the bank's predicament. The respective market values of the bank's asset and liability are:

100MM (1.032)5/(1.060)4=92.72MM

100MM(1.030) = 103.0MM

From a market-value accounting standpoint, the bank has lost USD 10.28MM.

So which result offers a better portrayal of the bank' situation, the accrual accounting profit or the market-value accounting loss? The bank is in trouble, and the market-value loss reflects this. Ultimately, accrual accounting will recognize a similar loss. The bank will have to secure financing for the loan at the new higher rate, so it will accrue the as-yet unrecognized loss over the 4 remaining years of the position.

(Source: RiskGlossary.com)

The problem in this example was caused by a mismatch between assets and liabilities. Prior to the 1970's, such mismatches tended not to be a significant problem. Interest rates in developed countries experienced only modest fluctuations, so losses due to asset-liability mismatches were small or trivial. Many firms intentionally mismatched their balance sheets. Because yield curves were generally upward sloping, banks could earn a spread by borrowing short and lending long.

Things started to change in the 1970s, which ushered in a period of volatile interest rates that continued into the early 1980s. US regulation Q, which had capped the interest rates that banks could pay depositors, was abandoned to stem a migration overseas of the market for USD deposits. Managers of many firms, who were accustomed to thinking in terms of accrual accounting, were slow to recognize the emerging risk. Some firms suffered staggering losses. Because the firms used accrual accounting, the result was not so much bankruptcies as crippled balance sheets. Firms gradually accrued the losses over the subsequent 5 or 10 years.

STRATEGIES FOR ASSET / LIQUIDITY MANAGEMENT

The principal purpose of asset / liability management has been to control the size of the net interest income. The control may be defensive or aggressive. The goal of defensive asset/liability management is to insulate the net interest income from changes in interest rates. In contrast, aggressive asset/liability management focuses on increasing the net interest income by altering the portfolio of the institution.

Both defensive and aggressive asset / liability management relate to the management of the interest rate sensitivity position of the asset and liability portfolio of the bank, and the success or failure of the strategies depend upon the effects of interest rates. For the success of the aggressive asset / liability management, it is necessary to forecast future interest rate changes. On the other hand, defensive strategy does not require the forecast of future interest rate changes. The attempt is to isolate the bank from either an increase or decrease in the rates.

USING FUTURES, OPTIONS AND SWAPS

Some relatively new techniques that can be used by banks to mange their asset / liability portfolio include future, option and swaps. Although these instruments have come into vogue in the last two decades in the US and Europe, they have experienced a tremendous growth and are becoming very significant in asset / liability management. Although these techniques are used primarily in defensive asset / liability management, they can also be used in aggressive management.

The adjustments to the bank’s portfolio involve changing the current cash or spot market positions in the portfolio of assets and liabilities. Equivalent adjustment in the bank’s interest sensitive positions can be achieved through transactions in the future markets. A future contract is a standardized agreement to buy or sell a specified quantity of a financial instrument on a specified future date at a set price. These future transactions in effect create synthetic positions with interest sensitivity positions different from those currently held in the portfolio.

One of the other major techniques used to manage interest rate risk is the interest rate swap. In an interest rate swap, two firms that want to change their interest rate exposure in different directions get together (usually through an intermediary) and exchange(swap) their obligation to pay interest. Only the interest is swapped and not the principal. Compared to futures, swaps have both advantages and disadvantages. First swaps may be customized to meet the needs of the banks. Secondly, swaps can be arranged for longer terms (say 3 to 10 years) whereas futures contracts are usually of shorter duration (usually under 6 months). Swaps also have disadvantage compared to future contract. As swaps are customized contracts, it involves time (and expense) in getting the right swap transactions. Second due to the customization, it is difficult to correctly

evaluate a swap and close out a contract, compared to futures. Equally significantly, the bank that enters into a swap agreement faces the risk of counterparty default.

AGGRESSIVE GAP MANAGEMENT

Management may choose to focus on the Gap in controlling the interest rate risk of its portfolio. This strategy seeks to profit from the anticipated interest rate movements. With an aggressive interest rate risk management programme, the first step is to make a prediction of future interest rates. Second, adjustments are made to the interest sensitivity of the assets and liabilities in order to take advantage of the projected changes in rates. The prediction of rising interest rates generally results in shifting to a positive gap, whereas the prediction of falling interest rates generally results in shifting the portfolio to a negative Gap position.

DEFENSIVE GAP MANAGEMENT

In a defensive Gap management strategy, the aim is to reduce the volatility of the net interest income. Unlike the aggressive strategy, there is no attempt to profit from the anticipated change in rates. The defensive strategy attempts to keep the volume of rate sensitive assets in balance with that of rate sensitive liabilities over a given period. If successful, an increase in the interest rates will produce equal increases in interest revenue and interest expense, with the result that net interest income and net interest margin will not change.

It is important to note that a defensive strategy is not necessarily a passive strategy. Continuous adjustments to the assets and liability portfolio are necessary to maintain zero Gap. For example, suppose a variable rate loan was paid off. If the Gap were zero prior to the pay-off, it would be negative afterwards and adjustments will have to be made. In order to restore the zero Gap, the manager would have to add short term securities.

PROBLEMS IN GAP MANAGEMENT

Although widely used in practice, Gap, management (whether aggressive or defensive) has a number of drawbacks. The first complication is the selection of the time horizon. As discussed earlier, the separation of assets and liabilities into rate sensitive and non – rate sensitive requires the establishment of a time horizon. Although necessary, the selection of the time horizon causes problems because it ignores the time at which the interest rate sensitive assets are repriced, implicitly assuming that all rate sensitive assets and liabilities are repriced on the same day. As examples of the problem caused by such an assumption, consider a bank which has zero Gap. Further assume that the maturity of the rate sensitive assets is one day, that of the rate sensitive liabilities

30days and the time horizon selected is 30days.given these assumptions, interest rate changes clearly would affect the net interest income of the bank even though it had zero Gap. One common solution to this problem is to divide assets and liabilities into separate categories referred to as maturity buckets and mange each maturity bucket separately. With the buckets, Gap management becomes management of the different buckets. The Gap for each maturity bucket is referred to as an incremental Gap. The incremental Gap of all the buckets is added to get the total Gap.

The second problem with Gap management is the implicit assumption that the correlation coefficient between the movement in general market interest rate and the interest revenue and costs to the bank are constant. In other words, if interest rat rise or fall by one percent, the revenues and interest costs to the bank will also rise or fall by one percent. One method of dealing with the problem imperfect correlation is the use of standardized Gap. This measure of Gap adjust for the different interest rate volatilities of various assets and liabilities. It uses the historical relationship between market rates and rates for a bank’s asset and liability items in order to alter the maturity and therefore the sensitivity of the portfolio items.

A problem related to aggressive Gap management is the need to make interest rate forecasts. With a lot of assumptions, rate forecast are made and based on these a number of decision are made. A final problem with the Gap management is its narrow focus on net interest income as opposed to shareholder wealth. An asset/liability manager may adjust portfolio so that the net interest income will rise with changes in interest income but the value of shareholder wealth may decrease. Aggressive asset/liability management based on interest rate predictions may increase the risk of loss. If successful, aggressive Gap management may increase net income but add to the volatility of that income.

DURATION GAP MANAGEMENT

The deficiencies of traditional Gap management, especially the focus on accounting income rather than on the market value of the equity, have encouraged a search for alternative approaches to asset/liability management one such approach is Duration Gap management. Duration analysis focuses directly on the market value of the equity of the bank, where market value represents the present value of the current and expected future income. With this analysis, durations of the assets and liabilities of the bank are computed in order to estimate the effects of changing interest rates on the market value of the assets and liabilities. Once the duration are computed, the effects of changing in interest rates can be measured simply by taking the sum of the changes in the market value of the assets and liabilities.

As in the case of traditional Gap management, there are two strategies that can be adopted with Duration Gap management – aggressive and defensive. The aim in the aggressive duration gap management is to maximize the market value of the equity. A defensive duration gap management would aim to isolate the market value of the equity from changes in the interest rates. The below table summarises the effects of interest rate changes on different types of Duration Gap.

Duration Gap

Net Interest Income Change in Market Value of Equity

Positive Increase DecreasePositive Decrease IncreaseNegative Increase IncreaseNegative Decrease DecreaseZero Increase ZeroZero Decrease Decrease

PROBLEMS IN DURATION GAP MANAGEMENT

Compared to the traditional Gap management, Duration Gap management provides additional insights which are useful to the asset/liability manager. However, it also suffers from several drawbacks. The primary drawback of Duration Gap management is that this technique is only effective if interest rates across different maturities move up or down by the same amount, i.e., a parallel shift in the yield curve. Unfortunately this assumption is not valid, as short term interest rates tend to move up faster than long term rates. Also in the case of falling rates, the short term rates fall much faster than the long term rates. An additional problem arises if the asset and liability durations are significantly different. In that case, comparing durations is not enough and additional measures such as convexity are required. The final problem is usually referred to as the duration drift. This is the problem where some items in the portfolio have a faster rate of decrease in the duration compared to others. In that case, zero duration portfolios may suddenly become positive or negative duration gap portfolios. This problem can be mathematically understood if we look at duration as the first derivative and that changes in the first derivative depend on the price yield curve of the instrument.

ROLE OF RESERVE BANK OF INDIA

The RBI, through its credit policy announcements, various directives and guidelines on ALM, has spelt out the need for having a comprehensive risk management policy. The RBI, in its monetary and credit policy and subsequent guidelines issued in February 1999, recommended that an adequate system of ALM be put in place. Further, it even suggested that financial institutions should introduce ALM, which would primarily focus on liquidity management and interest rate risk management. Having, thus, laid these requirements to implement ALM, in the stated order:

(A) Developing a better understanding of ALM concepts(B) Introducing an ALM information system(C) Setting up ALM decision – making process (ALM committee / ALCO), it is

for the institutions to act and implement the same.

ROLE OF FINANCIAL INSTITUTIONS

The concept of ALM and setting up the decision making process i.e., ALM committee have fairly established in the system. Binder and Lindquist, who conducted a study for Bank Administration Institute, highlighted the importance of asset liability. They reported that there was a strong agreement among the banks that ALM committee “is the single most important management group and function in the bank.” However, the introduction of ALM information system and implementing the process has been a tough task for the institutions. It has, at the same time, thrown up new challenges for the institutions. Challenges in the interest rate movements, their volatility and resistance to adopt a new procedural requirement, etc.

EXAMPLE:United Western Bank to merge with IDBI

PROBLEMS

There were several problems that led to the fall of UWBL that once had reached the 'A' class bank category. Irregular transactions with some of its major shareholders, conflicts between its major shareholders regarding the ownership of the bank, poor governance and inefficient management of capital were the main reasons for its collapse.

FINANCIALS OF UWB

UWB reported a net loss of Rs 104 crore on total income of 547 crore for the financial year 2005-06. For the quarter ended 30 June 2006, the bank posted a loss of Rs 6.1 crore on total income of around Rs 155 crore. Equity capital and reserves were close to Rs 114 crore but capital adequacy was just 0.67 per cent as of the end of June 2006, as against the RBI norm of 9 per cent.

Non-performing or bad assets in the books of UWB are estimated at around Rs 200 crore as of end June 2006. Most bankers expect UWB's bad assets to increase considerably, once a proper evaluation is made.

It is very clear that bad loans have wiped out the entire net worth of the UWB. The bank was planning a rights issue to shore up its capital base and had last month filed a draft offer letter with SEBI.

IDBI announced that the financial performance of UWBL would be merged with the financial performance of IDBI in the third quarter of the financial year 2006-07

EXAMPLE :

One example is the US mutual life insurance company the Equitable. During the early 1980s, the USD yield curve was inverted, with short-term interest rates spiking into the high teens. The Equitable sold a number of long-term guaranteed interest contracts (GICs) guaranteeing rates of around 16% for periods up to 10 years. During this period, GICs were routinely for principal of USD 100MM or more. Equitable invested the assets short-term to earn the high interest rates guaranteed on the contracts. Short-term interest rates soon came down. When the Equitable had to reinvest, it couldn't get nearly the interest rates it was paying on the GICs. The firm was crippled. Eventually, it had to demutualize and was acquired by the Axa Group.

Increasingly, managers of financial firms focused on asset-liability risk. The problem was not that the value of assets might fall or that the value of liabilities might rise. It was that capital might be depleted by narrowing of the difference between assets and liabilities—that the values of assets and liabilities might fail to move in tandem. Asset-liability risk is a leveraged form of risk. The capital of most financial institutions is small relative to the firm's assets or liabilities, so small percentage changes in assets or liabilities can translate into large percentage changes in capital.

Exhibit 1 illustrates the evolution over time of a hypothetical company's assets and liabilities. Over the period shown, the assets and liabilities change only slightly, but those slight changes dramatically reduce the company's capital (which, for the purpose of this example, is defined as the difference between assets and liabilities). In Exhibit 1, the capital falls by over 50%, a development that would threaten almost any institution.

Example: Asset-Liability RiskExhibit 1

Asset-liability risk is leveraged by the fact that the values of assets and liabilities each tend to be greater than the value of capital. In this example, modest fluctuations in values of assets and liabilities result in a 50% reduction in capital

(Source: RiskGlossary.com)

Techniques for assessing asset-liability risk came to include gap analysis and duration analysis. These facilitated techniques of gap management and duration matching of assets and liabilities. Both approaches worked well if assets and liabilities comprised fixed cash flows. Options, such as those embedded in mortgages or callable debt, posed problems that gap analysis could not address. Duration analysis could address these in theory, but implementing sufficiently sophisticated duration measures was problematic. Accordingly, banks and insurance companies also performed scenario analysis.

Techniques for assessing asset-liability risk came to include gap analysis and duration analysis. These facilitated techniques of gap management and duration

matching of assets and liabilities. Both approaches worked well if assets and liabilities comprised fixed cash flows. Options, such as those embedded in mortgages or callable debt, posed problems that gap analysis could not address. Duration analysis could address these in theory, but implementing sufficiently sophisticated duration measures was problematic. Accordingly, banks and insurance companies also performed scenario analysis.

CONCLUSION

One of the key conclusions from this analysis is that banks should take some amount of risk in their asset/liability management, but they should never wager their future on interest rate predictions. The financial institutions have recognized the importance of ALM, its utility in addressing the liquidity concerns and in managing the risk that the institutions are exposed to. The need of the hour is prudent and diligent management of these risks. How to manage them is the challenge and if it is successfully managed, the rewards could be stunning. The Deputy Governor of the RBI says, “Going forward, there will be a continuous need to adopt the strategy of liquidity management. the key questions we continue to face are what should be the instruments and modes of management of liquidity in the interest of growth and financial stability.

BIBLIOGRAPHY

BOOKS :

Managing Indian Banks, The Challenges Ahead, 2nd Edition, Sage publication, Author – Vasant C. Joshi & Vinay V. Joshi, chapter 11, Asset/liability management Pg No. 226 to 238

MAGAZINES:

E. N. Murthy, “Managing assets and liabilities”, ICFAI journal Professional Banker(March 2008) Pg No. 11 to 13