Assets Liabilities Management

ACKNOWLEDGEMENT

We hereby express our sincere thanks to Ms. Karishma Chawla, BCIDS

(SPJIMR), for her support, suggestions and encouragement throughout our
work.

We also thank her for her constant supervision and guidance throughout the
project work. We are also grateful to all faculty members at BCIDS for their
support.

PRASHANT AGRAWAL

SHOBHIT SONKAR

NIDHI CHANDRA

HITESH WAGHELA

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 Assets Liabilities Management

DECLARATION

We, Prashant Agrawal, Shobhit Sonkar, Nidhi Chandra, Hitesh Waghela

students of APPFSM of BCIDS, hereby declare that this project report entitled
“ASSETS AND LIABILITY MANAGEMENT” is prepared by us during the
academic year 2009-2010 under the guidance and supervision of Ms. Karishma
Chawala, Faculty member, BCIDS, Mumbai.

DATE:

PLACE: Mumbai

PRASHANT AGRAWAL

SHOBHIT SONKAR

NIDHI CHANDRA

HITESH WAGHELA

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 Assets Liabilities Management

LIST OF CONTENT

S.No. PARTICULARS PAGE

NO.
1 Balance sheet of YES Bank 5

2 Introduction 6

3 Component of Bank Balance Sheet 7

4 ALM in Bank 16

History of ALM 18

Objective of ALM 19

Purpose of ALM 20

5 ALM Process 21

6 ALM Organisation 25

7 Liquidity Management 29

8 Risk in ALM 32

 Interest Rate Risk 32

 Foreign Exchange Risk 32

 Liquidity Risk 32

 Credit Risk 34

9 Measuring and Managing Liquidity Risk 35

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 Assets Liabilities Management

Stock Approach 36

Flow Approach 36

10 Statement of Structural Liquidity 37

11 Gap Analysis 39

12 Duration Analysis 41

13 Success of ALM in Bank 42

14 Reference 43

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 Assets Liabilities Management

Balance Sheet of Yes Bank ------------------- in Rs. Cr. -------------------

Mar '07 Mar '08 Mar '09

12 mths 12 mths 12 mths

Capital and Liabilities:

Total Share Capital 280.00 295.79 296.98

Equity Share Capital 280.00 295.79 296.98
Share Application Money 0.00 0.00 0.00
Preference Share Capital 0.00 0.00 0.00
Reserves 507.06 1,023.13 1,327.24
Revaluation Reserves 0.00 0.00 0.00
Net Worth 787.06 1,318.92 1,624.22
Deposits 8,220.39 13,273.16 16,169.42
Borrowings 867.32 986.21 2,189.06
Total Debt 9,087.71 14,259.37 18,358.48
Other Liabilities & Provisions 1,228.68 1,404.13 2,918.10
Total Liabilities 11,103.45 16,982.42 22,900.80

Mar '07 Mar '08 Mar '09

Assets: 12 mths 12 mths 12 mths

Cash & Balances with RBI 389.76 959.24 1,277.72

Balance with Banks, Money at Call 903.08 668.33 644.99
Advances 6,289.73 9,430.27 12,403.09
Investments 3,073.12 5,093.71 7,117.02
Gross Block 86.66 133.01 194.88
Accumulated Depreciation 17.38 35.73 64.15
Net Block 69.28 97.28 130.73
Capital Work In Progress 1.59 3.89 0.39
Other Assets 376.88 729.70 1,326.86
Total Assets 11,103.44 16,982.42 22,900.80
Contingent Liabilities 51,724.67 65,990.12 39,632.14
Bills for collection 336.91 2,884.42 3,849.80
Book Value (Rs) 28.11 44.59 54.69

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 Assets Liabilities Management

Introduction
Asset Liability Management (ALM) defines management of all assets and

liabilities (both off and on balance sheet items) of a bank. It requires assessment

of various types of risks and altering the asset liability portfolio to manage risk.

Till the early 1990s, the RBI did the real banking business and commercial banks

were mere executors of what RBI decided. But now, BIS is standardizing the

practices of banks across the globe and India is part of this process. The success

of ALM, Risk Management and Basel Accord introduced by BIS depends on the

efficiency of the management of assets and liabilities. Hence these days without

proper management of assets and liabilities, the survival is at stake. A bank’s

liabilities include deposits, borrowings and capital. On the other side of the

balance sheets are assets which are loans of various types which banks make to

the customer for various purposes. To view the two sides of banks’ balance

sheet as completely integrated units has an intuitive appeal. But the nature,

profitability and risk of constituents of both sides should be similar. The structure of

banks’ balance sheet has direct implications on profitability of banks especially in

terms of Net Interest Margin (NIM).So it is absolute necessary to maintain

compatible asset-liability structure to maintain liquidity, improve profitability and

manage risk under acceptable limits.

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 Assets Liabilities Management

COMPONENTS OF A BANK BALANCE SHEET

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

Contingent Liabilities

1. 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.

2. Reserves & Surplus

Components under this head include:

I. Statutory Reserves
It is the amount of money any bank has to maintain with the
Reserve bank for every customer. Say you deposit Rs. 100 in ABC
Bank, the bank cannot lend all the 100 bucks. They have to pledge
a small amount say Rs. 10 with RBI and can lend only the
remaining 90 and make an income out of that 90.This 10 bucks is
the statutory reserve. The RBI modifies this reserve periodically.

II. Capital Reserves

The expression ‘capital reserves’ shall not include an amount
regarded as free for distribution through the profit & loss account.

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 Assets Liabilities Management

Surplus on revaluation or sale of fixed assets should be treated as

capital reserves

III. Investment Fluctuation Reserve

The net profits and losses of an investment company from the
purchase and sale of securities shall be respectively credited and
debited by the company to a reserve account to be kept by it and to
be called the "investment fluctuation reserve

IV. Revenue and Other Reserves

The expression ‘Revenue Reserves’ shall mean any reserve other
than capital reserve. This item will include all reserves, other than
those separately classified.

V. Balance in Profit and Loss Account

Includes balance of profit after appropriations. In the case of loss
balance may be shown as a deduction.

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
Includes all banks deposits repayable on demand. Others Includes
all demand deposits of the non-bank sectors. Credit balances in
overdrafts, cash credit accounts deposits payable at call, overdue
deposits, inoperative current accounts, matured time deposits and
cash certificates, etc. are to be included under this category.

II. Savings Bank Deposits

Includes all savings bank deposits (including inoperative
savings bank accounts).Includes all types of banks
deposits repayable after a specified term.Includes all
types of deposits of the non-bank sector repayable after
specified term. Fixed deposits, cumulative and
recurring deposits, cash certificates, annuity deposits,
deposits mobilised under various schemes, ordinary staff

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 Assets Liabilities Management

deposits, foreign currency non-resident deposits.

4. Borrowings

(Borrowings include Refinance / Borrowings from RBI, Inter-

bank & other institutions)

Includes borrowings/refinance and rediscount obtained from Reserve Bank of

India.Includes borrowings/refinance and rediscount obtained from commercial
banks (including co-operative banks) Includes borrowings/refinance and
rediscount from Industrial Development Bank of India, Export-Import Bank of
India, National Bank for Agricultural and Rural Development and other
institutions, agencies (including liability against participation certificates, if
any)
Includes borrowings and rediscounts of Indian branches abroad
as well as borrowings of foreign branches.
This item will be shown separately: Includes secured borrowings/refinance in
India and outside India.

5. Other Liabilities & Provisions

It is grouped as under:
 Bills Payable
 Inter Office Adjustments (Net)
 Interest Accrued
 Unsecured Redeemable Bonds
 (Subordinated Debt for Tier-II Capital)
 Others(including provisions

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 Assets Liabilities Management

Components of Assets

1. Cash & Bank Balances with RBI

Includes cash in hand including foreign currency notes foreign and also
foreign branches in the case of banks having such branches. Includes the
balance maintained with the Reserve Bank of India in Current Account.

2. Balances with banks and money at call & short notice

Includes balances held with the Reserve Bank of India other than in current
accounts, if any. Includes all balances with banks in India (including co-
operative banks). Balances in current accounts and deposit accounts should be
shown separately. Includes deposits repayable within 15 days or less than 15
days’ notice lent in the inter-bank call money short other banks market notice in
India Includes balances held by foreign branches and balances held by Indian
branches of the banks outside India.
Balances held with foreign branches by other branches of the bank should
not be shown under this head but should be included in inter branch accounts.
The amounts held in ‘current accounts’ and ‘deposit accounts’ should be shown
separately. Includes deposits usually classified in foreign countries as money at
call and short notice.

3. Investments

A major asset item in the bank’s balance sheet. Reflected under 6

buckets as under:
I. Investments in India in :
 Government Securities
 Other approved Securities
 Shares
 Debentures and Bonds
 Subsidiaries and Sponsored Institutions
 Others (UTI Shares , Commercial Papers, COD &
Mutual Fund Units etc.)

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 Assets Liabilities Management

II. Investments outside India in

  Subsidiaries and/or Associates abroad

4. Advances

In classification under Section ‘A’, all outstandings – in India as well as outside

– less provisions made, will be , classified under three heads as indicated and
both secured and unsecured advances will be included under these heads.

All advances or part of advances which are secured by tangible assets may be
shown here. The item will include advances in India and outside India.
Advances in India and outside India to the extent they are covered by
guarantees of Indian and foreign governments and Indian and foreign banks are
to be included. All advances not classified under (i) and (ii) will be included
here.
Advances should be broadly classified into ‘Advances in India’ and ‘Advances
outside India’. Advances in India will be further classified on the sectoral basis
as indicated advances to sectors which for the time being are classified as
priority sectors according to the instructions of the Reserve Bank are to be
classified under the head ‘Priority sectors’. Advances to Central and State
Governments and other Government undertakings including Government
companies and corporations which are, according to the statutes, to be
treated as ‘public sector’. All advances to the banking sector including co-
operative banks will come under the head ‘Banks’. All the remaining advances

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 Assets Liabilities Management

will be included under this head ‘Others’ and typically this category will include
non-priority advances to the private, joint and co-operative sectors.

5. Fixed Asset

I. Premises

Premises wholly or partly owned by the banking company for the purpose of
business including residential premises should be shown against ‘Premises’. In
the case of premises and other fixed assets, the previous balance, additions
thereto and deductions there from during the year as also the total depreciation
written off should be shown. Where sums have been written off on reduction of
capital or revaluation of assets, every balance sheet after the first balance sheet
subsequent to the reduction or revaluation should show the revised figures with
the date and amount of revision made.

II. Other Fixed Assets (Including furniture and fixtures)

Motor vehicles and all other fixed assets other than furniture premises but
including furniture and fixtures should be shown under this head.

6. Other Assets

I. Interest accrued

Interest accrued but not due on investments and advances and interest due but
not collected on investments will be the main components of this item. As banks
normally debit the borrowers’ account with interest due on the balance sheet
date, usually there may not be any amount of interest due on advances. Only

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 Assets Liabilities Management

such interest as can be realised in the ordinary course should be shown under
this head.

II. Tax paid in advance/tax deducted at source

(Net of Provisions)

The amount of tax deducted at source on securities, .advance tax paid, etc. to the
extent that these items are not set off against relative tax provisions should be
shown against this item.

III. Stationery and Stamps

Only exceptional items of expenditure on stationery like bulk purchase of

security paper, loose leaf or other ledgers, etc. which are shown as quasi-asset to
be written off over a period of time should be shown here. The value should be
on a realistic basis and cost escalation should not be taken into account, as these
items are for internal use.

IV. Others

This will include non-banking assets and items like claims which have not been
met, for instance, clearing items, debit items representing addition to assets or
reduction in liabilities which have not been adjusted for technical reasons, want
of particulars, etc. advances given to staff by a bank as employer and not as a
banker, etc. Items, which are in the nature of expenses, which are pending
adjustments, should be provided for and the provision netted against this item so
that only realisable value is shown under this head. Accrued income other than
interest may also be included here.

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 Assets Liabilities Management

Contingent Liability

Bank’s obligations under LCs, Guarantees, Acceptances on behalf of

constituents and Bills accepted by the bank are reflected under this heads.

RECLASSIFICATION OF ASSETS &

LIABILITIES

The assets and liabilities of a Bank are divided into various sub heads. For the
purpose of the study, the assets were regrouped under six major heads and the
liabilities were regrouped under four major heads as shown in table below. This
classification is guided by prior information on the liquidity-return profile of assets
and the maturity-cost profile of liabilities. The reclassified assets and liabilities
covered in the study exclude ‘other assets’ on the asset side and ‘other liabilities’
on the liabilities side. This is necessary to deal with the problem of singularity
– a situation that produces perfect correlation within sets and makes correlation
between sets meaningless.

Reclassification of Liabilities
Net Worth Capital, Reserves and Surpluses

Borrowing Borrowing from RBI, banks, other FlIs both

from India and Abroad

Short term Deposits Demand Deposits and Savings Bank

Deposits

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 Assets Liabilities Management

Loan Term Deposit All deposit not included in short term

Table Reclassification of Assets

Liquid Assets Cash in hand,Balance with RBI,Bal with
Bank,Money at Call and short notice

SLR Securities Govt Securities and other approved

Securities

Investment Other than SLR such as shares,Debentures

bonds,subsidiaries and others

Term Loans Term loan

Short term Loans Advances not in TL Bill Purchased and
discounted cash credit ,overdraft and loans

Fixed Assets Fixed Assets

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Asset liability management in banks

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 Assets Liabilities Management

INTRODUCTION:

Definition
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.

 An attempt to match:

Assets and Liabilities

To explore the relationship between assets and liabilities, we could merely compute
the correlation between each set of assets and each set of liabilities.
Unfortunately, all of these correlations assess the same hypothesis - that assets
influence liabilities. Hence, a Bonferroni adjustment needs to be applied. That is,

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we should divide the level of significance by the number of correlations. This

Bonferroni adjustment, of course, reduces the power of each correlation and thus
can obscure the findings. Canonical correlation provides a means to explore all
of the correlations concurrently andthus obviates the need to incorporate a
Bonferroni adjustment. The technique reduces the relationship into a few
significant relationships.The essence of canonical correlation Measures the
strength of relationship between two sets of variables (Assets (6) & Liabilities (4)
in this case) by establishing linear combination of variables in one set and a
linear combinations of variables in other set. It produces an output that shows the
strength of relationship between two variates as well as individual variables
accounting for variance in other set
.
A = A1 * (Liquid Assets) + A2 * (SLR Securities)+ A3 * (Investments) + A4 *
(Term Loans) + A5 *
(Short Term Loans) + A6 * (Fixed Assets)

B = B1 * (Net Worth) + B2* (Borrowings) + B3 *(Short Term Deposits) + B4 *

(Long Term Deposits)
To begin with, A and B (called canonicalvariates) are unknown. The technique
tries to compute the values of Ai and Bi such that the covariance between A & B
is maximum.

Asset Liability Management

Asset Management Liability Management

How Liquid are the assets of How easy can the bank
the Bank 18generate loans from market
 Assets Liabilities Management

HISTORY OF ALM

Historically, ALM has evolved from the early practice of managing liquidity on
the bank's asset side, to a later shift to the liability side, termed liability
management, to a still later realization of using both the assets as well as
liabilities sides of the balance sheet to achieve optimum resources management.
But that was till the 1970s. In the 1980s, volatility of interest rates in USA and
Europe caused the focus to broaden to include the issue of interest rate risk.
ALM began to extend beyond the bank treasury to cover the loan and deposit
functions. The induction of credit risk into the issue of determining adequacy of
bank capital further enlarged the scope of ALM in later 1980s.

Deregulation of interest rates

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 Assets Liabilities Management

Interest Rate Risk

s
Liquidity Risk Credit Risk

In the current decade, earning a proper return of bank equity and hence
maximization of its market value has meant that ALM covers the management
of the entire balance sheet of a bank. This implies that the bank managements
are now expected to target required profit levels and ensure minimization of
risks to acceptable levels to retain the interest of investors in their banks. This
also implies that costing and pricing policies have become of paramount
importance in banks.

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
 Aim is to stabilize the short-term profits, long-term earnings and long-
term substance of the bank. The parameters that are selected for the
purpose of stabilizing asset liability management of banks are:
-Net Interest Income (NII)
Interest Income-Interest Expenses
-Net Interest Margin (NIM)
Net Interest Income/Average Total Assets

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 Assets Liabilities Management

-Economic Equity Ratio

The ratio of the shareholders funds to the total assets measures the shifts
in the ratio of owned funds to total funds. The fact assesses the sustenance
capacity of the bank.

PURPOSE OF ALM

 Review the interest rate structure and compare the same to the
interest/product pricing of both assets and liabilities
 Examine the loan and investment portfolios in the light of the
foreign exchange risk and liquidity risk that might arise.
 Examine the credit risk and contingency risk that may originate
either due to rate fluctuations or otherwise and assess the quality
of assets.
 Review,the actual performance against the projections made and
analyse the reasons for any effect on spreads

ALM PROCESS

The scope of ALM function can be described as follows:

 Liquidity Risk Management

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 Assets Liabilities Management

It is the risk of having insufficient liquid assets to meet the liabilities

at a given time.

 Management of Market Risks

Market risk is the risk that the value of a portfolio, either an investment

portfolio or a trading portfolio, will decrease due to the change in value of the
market risk factors.
Market Risks are:

 Equity risk, the risk that stock prices and/or the implied volatility will
change.
 Interest rate risk, the risk that interest rates and/or the implied
volatility will change.
 Currency risk, the risk that foreign exchange rates and/or the implied
volatility will change.
 Commodity risk, the risk that commodity prices (e.g. corn, copper, crude
oil) and/or implied volatility will change.

 Trading Risk Management

Proper risk management is a key to success in forex trading. Learning how to

manage your risk can make or break your trading career. Trading Risk
Management includes:

 Introduction to Risk Management

 Managing Risk on a Demo Account
 Choosing a Lot Size
 Extreme Leverage
 Risk Reward Ratio
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 Assets Liabilities Management

 Surviving a wild forex market

 Risk Management Ideas
 Money Management Basics
 Position Sizing
 Limiting Losses
 Creating a Trading Plan

 Funding and Capital Planning

Capital budgeting (or Capital planning) is the planning process used to

determine the budget for major capital, or investment, expenditures.

Many formal methods are used in capital budgeting, including the techniques
such as

 Accounting rate of return

 Net present value
 Profitability index
 Internal rate of return
 Modified internal rate of return
 Equivalent annuity

When a corporation determines its capital budget, it must acquire said funds.
Three methods are generally available to publicly traded corporations: corporate
bonds, preferred stock, andcommon stock. The ideal mix of those funding
sources is determined by the financial managers of the firm and is related to the
amount of financial risk that corporation is willing to undertake. Corporate
bonds entail the highest financial risk and therefore generally have the lowest
interest rate. Preferred stock have no financial risk but dividends, including all
in arrears, must be paid to the preferred stockholders before any cash

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 Assets Liabilities Management

disbursements can be made to common stockholders; they generally have

interest rates higher than those of corporate bonds. Finally, common stocks
entail no financial risk but are the most expensive way to finance capital
projects.

 Profit Planning and Growth Projection

Profit is an essential cost of business activity and must be planned and managed
just like other costs.  Successful business performance requires balancing costs
and revenues as illustrated by the following model.

Costs of the future (profit) + current costs (expenses) = Average revenue per
unit sold x sales volume (net revenue).

The effective manager must make trade-offs among these variables to keep this
equation in balance and this requires effective profit planning. 

Advantages of Profit Planning

 Performance evaluation
 Awareness of responsibilities.
 Cost consciousness
 Disciplined approach to problem-solving
 Thinking about the future
 Financial planning
 Confidence of lenders and investors

Why ALM?

• One-line answer – to manage NIM

• How NIM is linked to ALM?

Planning process of a Commercial Bank

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 Assets Liabilities Management

1. Day-to-day week-to-week Balance Sheet management to achieve

short-term fin goals
2. Annual Profit Planning
3. Strategic planning- long term fin and non-fin aspects

ALM ORGANISATION

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 Assets Liabilities Management

Board of Directors

Management
Committee

Asset Liability Committee

(ALCO)

Asset Liability Management

Cell

Finance Planning Department

Credit Analysis Credit Risk Treasury

Department Management
Department

Investment and Loan Departments

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

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 Assets Liabilities Management

bank (on the assets and liabilities sides) in line with the bank's budget and
decided risk management objectives.

c) 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 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 .
Banks 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.

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 Assets Liabilities Management

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 Assets Liabilities Management

LIQUIDITY MANAGEMENT
(Project focus on Liquidity Management)

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.

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 Assets Liabilities Management

Banks need liquidity to meet deposit withdrawal and to fund loan

demands. The variability of loan demands and variability of deposits
determine bank’s liquidity needs. It represents the ability to accommodate
decreases in liability and to fund increases in assets. It demonstrates the
market place that the bank is safe and therefore capable of repaying its
borrowings. It enables bank to meet its prior loan commitments, whether
formal or informal. It enables bank to avoid the unprofitable sale of
assets. It lowers the size of the default risk premium the bank must pay
for funds.

ADEQUACY OF LIQUIDITY POSITION FOR A BANK  

  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
 Present and planned capital position 
 

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
 Increase Capital fund

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 Assets Liabilities Management

RISKS IN ALM

 Interest Rate Risk

 Foreign Exchange Risk
 Liquidity Risk
 Credit Risk
 Contingency Risk
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 Assets Liabilities Management

 Interest Rate Risk: 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.

 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.

 Liquidity Risk: It is the risk of having insufficient liquid

assets to meet the liabilities at a given time.

TYPES OF LIQUIDITY RISK:

• Liquidity Exposure can stem from both internally and

externally.
• External liquidity risks can be geographic, systemic or
instrument specific.
• Internal liquidity risk relates largely to perceptions of an
institution in its various markets: local, regional, national or
international.

OTHER CATEGORIES OF LIQUIDITY RISK:

 Funding Risk
 Time Risk
 Call Risk.

 Funding Risk:

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 Assets Liabilities Management

Need to replace net outflows due to unanticipated withdrawal/non-

renewal of deposits arises due to :
-Fraud causing substantial loss
-Systemic Risk
-Loss of confidence
-Liabilities in foreign currencies

 Time Risk:

Need to compensate for non-receipt of expected inflow of funds,

arises due to,
-Severe deterioration in the asset quality
-Standard assets turning into non-performing
assets
-Temporary problems in recovery
-Time involved in managing liquidity

 Call Risk:

Crystallisation of contingent liabilities and inability to undertake

profitable business oppurtunities when desirable,arises due to,
-Conversion of non-fund based limit into fund based. -Swaps
and options.

How do a bank manages it’s liquidity risk?

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

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 Assets Liabilities Management

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.
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.

STEPS IN MEASURING AND MANAGING LIQUIDITY

RISK

 Developing a structure for managing liquidity risk.

 Setting tolerance level and limit for liquidity risk.
 Measuring and managing liquidity risk

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Setting tolerance level for a bank:

 To manage the mismatch levels so as to avert wide

liquidity gaps-The residual maturity profile of assets and
liabilities will be such that mismatch level for time bucket
of 1-14 days and 15-28 days remain around 20% of cash
outflows in each time bucket.
 To manage liquidity and remain solvent by maintaining
short-term cumulative gap up to one year(short term
liabilities-short term assets at 15% of total outflow of
funds.

Measuring and Managing Liquidity Risk

 Stock Approach
 Flow Approach

Stock Approach :

It is based on the level of assets and liabilities as well as off balance

sheet exposures on a particular date.The following ratios are
calculated to assess the liquidity position of the bank:

- Ratio of core deposits to total assets

- Net loans to total deposits ratio

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-Ratio of time deposits to total deposits

- Ratio of volatile liabilities to total assets
- Ratio of short term liabilities to liquid assets
- Ratio of liquid assets to total assets
- Ratio of short term liabilities to total assets
- Ratio of prime assets to total assets
- Ratio of market liabilities to total assets.

Flow Approach:
-Measuring and managing net funding requirements.
-Managing Market Access
-Contingency Planning

Measuring and Managing net funding requirements:

 Flow method is the basic approach followed by Indian

Banks.It is called as gap method of measuring and
managing liquidity.It requires the preparation of structural
liquidity gap report.In this method net funding requirement
is calculated on the basis of residual maturities of assets &
liabilities.These residual maturities represent net cash
flows ie.difference between cash outflow & cash inflow in
future time buckets
 These calculations are based on the past behaviour pattern
of assets and liabilities as well as off balance
sheetexposures.Cumulative gap is calculated at various
time buckets.In case gap is negative bank has to manage
the shortfall.
 The analysis of net funding requirements involves the
construction of a maturity ladder and the calculation of a

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cumulative net excess or deficit of funds at selected

maturity dates.

Maturity ladder & calculation of cumulative

surplus/deficits at selected dates

Construction of time buckets:

1 to 30/31 days
Over 1 month and upto 2 months
Over 2 months and 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

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
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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.

ADDRESSING TO MISMATCHES

• Mismatches can be positive or negative

• Positive Mismatch: M.A.>M.L. and vice-versa for Negative
Mismatch
• 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.

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

Sources of Interest Rate Risk

Interest rate risk mainly arises from:

– Gap Risk

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 Assets Liabilities Management

– Basis Risk
– Net Interest Position Risk
– Embedded Option Risk
– Yield Curve Risk
– Price Risk
– Reinvestment Risk

Measurement of Interest Rate Risk

There are various techniques to measure this risk:

1. Gap Analysis
2. Duration Gap Analysis
3. Simulation
4. Value at Risk

GAP ANALYSIS

• The gap is the difference between the amount of assets and

liabilities on which the interest rates are reset during a given
period
• It arises on account of holding rate sensitive assets and liabilities
with different principal amounts, maturity/repricing rates
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 Assets Liabilities Management

• Even though maturity dates are same, if there is a mismatch

between amount of assets and liabilities it causes interest rate
risk and affects NII
• Calculating Gap over different time intervals at a given date
• Mismatches between RSL and RSA
• D GAP = RSA(D i) - RSL(D i) = NII(D i) for each time bucket
• Positive GAP ( RSA > RSL )
– Increasing Interest Rates would be beneficial for a Bank
• Negative GAP ( RSL > RSA )
– Falling Interest Rates would be beneficial for a Bank

IMPACT ON NII
Gap Interest rate Change Impact on NII

Positive Increases Positive

Positive Decreases Negative

Negative Increases Negative

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 Assets Liabilities Management

Negative Decreases Positive

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.

Interest Rate Risk Management

• 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.

SUCCESS OF ALM IN BANKS :

PRE – CONDITIONS

1. Awareness for ALM in the Bank staff at all levels–supportive

Management & dedicated Teams.
2. Method of reporting data from Branches/ other Departments.
(Strong MIS).
3. Computerization-Full computerization, networking.

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4. Insight into the banking operations, economic forecasting,

computerization, investment, credit.
5. Linking up ALM to future Risk Management Strategies.

REFERENCES:

 www.rbi.org.in
 www.wikipedia.org
 www.google.com
 www.almprofessional.com

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