Asset Liability Management of Banks and Financial Institutions

By: Professor.P.Madhu Sudana Rao

In banking institutions, asset and liability management is the practice of managing various risks that arise due to mismatches between the assets and liabilities (loans and advances) of the bank.

Banks face several risks such as the risks associated with assets,interest,currency exchange risks. Asset Liability management (ALM) is at tool to manage interest rate risk and liquidity risk faced by various banks, other financial services companies .

Mismatch of assets and liabilities:

Banks manage the risks of ALM mismatch by matching various assets and liabilities according to the maturity pattern or the matching the duration, by hedging and by securities.

Increasing integrated risks is done on a full mark to market basis rather than the accounting basis that was at the heart of the first interest rate sensitivity gap and duration calculations.

What is ALM;

It is an attempt to match: Assets and Liabilities In terms of: Maturities and Interest Rates Sensitivities To minimize: Interest Rate Risk and Liquidity Risk.

ALM is an integral part of the
financial management process of any bank. It is concerned with strategic balance sheet management involving risks caused by changes in the interest rates, exchange rates and the liquidity position of the bank. While managing these three risks forms the crux of ALM, credit risk and contingency risk also form a part of the ALM

ALM can be termed as a risk management technique designed to earn an adequate return while maintaining a comfortable surplus of assets beyond liabilities. It takes into consideration interest rates, earning power, and degree of willingness to take on debt and hence is also known as Surplus Management

Definition of ALM:

ALM is defined as, “the process of decision – making to control risks of existence, stability and growth of a system through the dynamic balances of its assets and liabilities.”

The text book definition of ALM :

It is “a risk management technique designed to earn an adequate return while maintaining a comfortable surplus of assets beyond liabilities. It takes into consideration interest rates, earning power and degree of willingness to take on debt. It is also called surplus- management”.

International scenes:

Over the last few years the financial markets worldwide have witnessed wide ranging changes at fast pace. Intense competition for business involving both the assets and liabilities, together with increasing volatility in the domestic interest rates as well as foreign exchange rates, has brought pressure on the management of banks to maintain a good balance among spreads, profitability and long-term viability.

These pressures call for structured and comprehensive measures and not just ad hoc action. The Management of banks has to base their business decisions on a dynamic and integrated risk management system and process, driven by corporate strategy. Banks are exposed to several major risks in the course of their business – credit risk, interest rate risk, foreign exchange risk, equity / commodity price risk, liquidity risk and operational risks.

The ALM process rests on three pillars:

1) ALM information systems

2) Management Information System

3) Information availability, accuracy, adequacy and expediency

ALM involves identification of Risk parameters, Risk identification, Risk measurement and Risk management and framing of Risk policies and tolerance levels.

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 behavioral pattern it will take time for banks in the present state to get the requisite information.

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:

It transcends individual institutions, as liquidity shortfall in one institution can have repercussions 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.

Various types of risks with assets:

Currency Risk;

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;

It 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.

Mismatched currency position besides exposing the balance sheet to movements in exchange rate also exposes it to country risk and settlement risk. Ever since the RBI (Exchange Control Department) introduced the concept of end of the day near square position in 1978, banks have been setting up overnight limits and selectively undertaking active day time trading.

Interest Rate Risk (IRR);

The phased deregulation of interest rates and the operational flexibility given to banks in pricing most of the assets and liabilities have exposed the banking system to Interest Rate Risk.

Interest rate risk is the risk where changes in market interest rates might adversely affect a bank’s financial condition. Changes in interest rates affect both the current earnings (earnings perspective) as also the net worth of the bank (economic value perspective). The risk from the earnings’ perspective can be measured as changes in the Net Interest Income (Nil) or Net Interest

Margin (NIM).

Problem with poor Management Information systems;

In the context of poor MIS, slow pace of computerisation in banks and the absence of total deregulation, the traditional Gap analysis is considered as a suitable method to measure the Interest Rate Risk. It is the intention of RBI to move over to modern techniques of Interest Rate Risk measurement like Duration Gap Analysis, Simulation and Value at Risk at a later date when banks acquire sufficient expertise and sophistication in MIS.

The Gap or mismatch risk can be measured by calculating Gaps over different time intervals as at a givendate. Gap analysis measures mismatches between rate sensitive liabilities and rate sensitive assets(including off-balance sheet positions). An asset or liability is normally classified as rate sensitive

if: The Gap Report should be generated by grouping rate sensitive liabilities, assets and off balance sheet positions into time buckets according to residual maturity or next reprising period, whichever is earlier. The difficult task in Gap analysis is determining rate sensitivity. All investments, advances, deposits, borrowings, purchased funds etc. that mature/reprice within a specified timeframe are interest rate sensitive. Similarly, any principal repayment of loan is also rate sensitive if the bank expects to receive it within the time horizon. This includes final principal payment and interim instalments. Certain assets and liabilities receive/pay rates that vary with a reference rate. These assets and liabilities are repriced at pre-determined intervals and are rate sensitive at the time of repricing. While the interest rates on term deposits are fixed during their currency, the advances portfolio of the banking system is basically floating. The interest rates on advances could be repriced any number of occasions, corresponding to the changes in PLR.

Risks in ALM :

It is the risk of having a negative impact on a bank’s future earnings and on the market value of its equity due to changes in interest rates. Liquidity Risk: It is the risk of having insufficient liquid assets to meet the liabilities at a given time.

Forex Risk: It is the risk of having losses in foreign exchange assets and liabilities due to exchanges in exchange rates among multi-currencies under consideration.

Conclusion; thus ALM is a continuous and day to day matter which has to be carefully managed and preventive steps taken to mitigate the problems associated with it. It may cause irreparable damage to the banks in terms of liquidity, profitability and solvency, if not monitored properly.

About the Author

Professor of Finance,Mekelle University,Mekelle, Ethiopia

Former professor,Kakatiya university,Warangal,A.P India

Former district coordinator,A.P.Productivity council,Hyderabad,

former Vice Chairman/director,Bhadradri Bank,Khammam,A.P.India

 

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