Chapter 2

Asset-Liability Management in Banks

This chapter begins with the discussion on classification of bank's assets and habiHties into

Banking Book and Trading Book. It then describes the meaning of 'Asset-LiabiHty

Management' and its role in handhng liquidity risk and interest rate risk. Finally, it

describes in detail, the computer based ALM system that was developed and implemented

in banks during the study.

2.1 The Banking and the Trading Book

Banks broadly position their balance sheet into Banking book and Trading Book. The

'banking book' groups and records all commercial banking activities. It includes all

lending and commercial borrowing activities such as bank deposits, borrowings and loans

and advances. The trading book comprises of securities such as bonds, equity, various

currency positions and commodity positions that are identified as a part of the trading

book. 'Conceptually, a Financial Institution's trading portfolio can be distinguished from

its banking portfolio on the basis of time horizon and liquidity.' (Saunders, 2003:232) The

important points on which these two differ from each other are as follows:

Holding Period: The assets and liabilities in the banking book are held till maturity;

whereas in case of trading book, the holding period can be as short as few minutes/hours to

a maximum of 90 days. The term 'trading' implies frequent and active buying and selling

to take advantage of temporary differences in market prices. Unlike the traditional

activities like deposit accepting and lending, in trading activities, banks make profits by

earning commissions on trading volume and by investing primarily in debt or equity

securities for their short term profit potential.

Accounting Rules: In case of banking book, accounting is done on the basis of accrual

basis and it relies on book values of assets and liabilities. Trading book relies on market

values of transactions which consider price appreciation (or depreciation) due to changes in

market conditions. Trading book is "marked to market" on daily basis, i.e. its valuation is

based on daily market prices of financial assets as opposed to their historical or acquisition

values (which is done in the case of a banking book).

J6

One more important issue in the risk management in the banking book is that it is spread

over a long time-period as compared to the risk management in trading portfoHos. This is

because, at a bank level, volume of a banking book in Indian banks generally outweighs

volume of a trading book and typically positions in the banking book are generally held till

maturity.

All assets and liabilities in the banking book generate accrued revenues and costs, of which

a large fraction is driven by the interest rates. Any maturity mismatch between assets and

liabilities results in surplus or deficit of funds. Mismatch may also exist due to customer's

demands or bank's business policy, e.g. when lending activity increases there may be

deficit of funds or growth in deposits that may lead to excess funds. This requires

simultaneous planning of all assets and liability positions on the bank's balance sheet. As

described by Moynihan (2002), using ALM techniques bank can mitigate the risks arising

out of changes in interest rates, provides adequate liquidity and enhances the value of the

bank. Such attempts of measuring financial risks, particularly risks related to interest rates

and liquidity positions are classified under the broad subject - "Asset-Liability

Management" (ALM).

2.2 Asset Liability Management: Background and Definition

Internationally, the phenomenon of asset-liability management (ALM) began in 1970s

when the markets observed increasing volatility in the interest rates. However, at that time

the Indian banks were still operating in protected environment as interest rates were guided

by the regulators. Prior to interest rate deregulation, financial management of a bank was

mainly limited to asset management. However, with liberalization and growing integration

of domestic and external markets the risks associated with bank's operations increased.

Deregulation of interest rates coupled with increased competition in mid-90s started

putting pressure on management to maintain spread and profitability. The changing nature

of sources (liabilities) and uses (assets) of funds highlighted the need for prudent liquidity

management and hence it was necessary to study the maturities of assets and liabilities in

structured manner by adopting comprehensive ALM practices.

17

Asset and Liability Management is broadly defined as the "coordinated management of

bank's balance sheet (portfolio) to allow for alternative interest rates, liquidity and

prepayment scenarios." (Sinkey, 2002 : 661). It is the process of planning, organizing and

controlling asset and liability mixes, volumes, yields and rates in order to achieve targeted

interest margin. The primary goal is to control interest income and expenses and to increase

the net interest margin on a continuous basis.

The entire subject of ALM is about balance sheet and its management. The management of

a firm's balance sheet is one of the important functions in risk management for financial

institutions. Hence it is necessary to know the components of Balance-sheet. Typically,

Indian commercial banks include following 'rate earning assets' and 'rate paying

liabilities' in their balance sheets. (Other assets and liabilities which are not significant

from ALM point of view are excluded.)

Assets

• Advances

Term Loans and Demand Loans

Un-availed portion of Cash Credit/Overdraft

Bills purchased and Discounted

• Investments

Government & Other Securities

Liabilities

Demand Deposits - Current and Savings Bank Deposits :Demand deposits can be

withdrawn on demand and hence do not have any specific maturity

Term Deposits - They are contracted for a specific term. They include Cumulative,

Non-cumulative and Recurring Deposits. Significant portion of them is at fixed -

rate.

Borrowings

2.3 Scope of ALM

From the above discussion it may be stated that in the overall risk management framework

of a bank ALM addresses the following important risks,

1. Liquidity Risk: The risk arising out of unexpected fluctuation in cash outflows and

cash inflows.

2. Interest Rate Risk: The risk arising due to changes in interest rates on assets and

liabilities.

These risks and may be explained as follows:

2.3.1 Liquidity Risk in the Banking Book

Liquidity risk is the potential inability to meet the bank's liabilities as they become due. It

arises when the banks are not able to generate enough cash to cope up with a decline in

deposits or increase in assets. "Liquidity risk arises for two reasons: a liability-side reason

and an asset-side reason" (Saunders, 2003: 424). The liability side risk occurs when

depositors ask for their claims without prior notification. The asset side risk occurs when

the borrower demands his loan commitment and the bank does not have sufficient funds to

fulfill his request.

The liquidity risk in the banking book can also be called as funding liquidity which arises

from mismatches in the maturity pattern of assets and liabilities. "Net funding

requirements are determined by analyzing the bank's future cash flows based on

assumptions of the future behaviour of assets and liabilities that are classified into

specified time buckets and then calculating the cumulative net flows over the time frame

for liquidity assessment." (RBI, 2002). An example of funding liquidity can be stated as

follows: Let us consider a single asset and single liability in the balance sheet. Let us

assume that the asset is a five-year old loan and the liability is 6-months term deposit. The

bank would face funding liquidity risk after one year when the 6-months old deposit

matures for payment, since the liability would require a cash out flow while the asset

would not have earned any cash flow (except the possible interest on the loan). This is a

typical case of funding mismatch that the bank can manage either when a customer renews

the matured deposit (rolling over) or gets fresh deposit or a combination of both. The

standard tools used to measure liquidity risk are: Liquidity Gap and Structural balance

sheet ratios.

2.3.1.1 The Liquidity Gap

One important approach to measuring liquidity risk at balance sheet level is to find out the

'liquidity gap'. "Liquidity gaps are the differences, at all future dates, between assets and

liabilities of the banking portfolio". (Bessis, 2002: 137) They are differences between

outstanding balances of assets and liabilities, or between their changes over time. Such

gaps cause the risk of not being able to generate funds without incurring excess costs.

Thus, the liquidity gap report is prepared by placing assets and liabilities into various time

buckets on the basis of timing of cash inflows from the assets and timings of cash outflows

from the liabilities on the basis of their residual maturities. The cash flow includes both

principal and interest cash flow. For regulatory purposes the RBI has suggested the

following format of liquidity report. (RBL 1999a)

Liquidity Gap Summary (Amount in Rs. Crores)

Particulars

A. Total

Outflows

B. Total

Inflows

C. Net Gap

(B-A)

D. Cumulative

Gap

1-14D 15-28D 29D-3M 3-6M 6M-1Y 1-3Y 3-5Y Over 5Y Total

( D: Day, M: Month, Y: Year)

Table 2.1

The advantage of the liquidity gap approach is that it is extremely simple to understand and

use. However, while using this approach some important issues need to be considered

through appropriate analysis. These issues are as follows,

20

1. Non maturity items in the balance sheet: A significant portion around 38% in

nationalized banks in the year 2004-05 (IBA,2005) of deposits in the banking

industry is in the form of current and savings deposits which do not have specific

maturity period. Similarly, advances in the form of cash credit, over-draft also do

not have any specific maturity. Such items which are of the 'non-maturity' variety

can result in cash flow at any time and hence it is difficult to place them in a

definite time period (bucket). For such items it is necessary to study their

behavioural maturity on the basis of statistical analysis and then place them in

appropriate time bucket.

2. Renewal assumptions in case of maturing deposits: Though the term deposits

result in cash outflow on maturity, the general practice is that a significant amount

of such deposits is actually renewed by the customers. Such renewals do not result

in cash outflow thereby reducing the net gap. It is difficult to predict the percentage

of renewal of deposits as it may vary from dme to time depending on various

factors such as prevailing interest rates, customer's need for cash, etc. If the

renewal percentage assumed for the preparation of gap report is more than the

actual renewal, it would create an unexpected deficit of liquidity. In the reverse

situation, surplus liquidity would result into less return as bank may not be able to

deploy the unexpected surplus. Considering this, it is necessary to have a detailed

roll-in / roll-out analysis of deposits. This analysis, if done over a reasonable

period, would enable the comparison of the actual renewals with the expected /

projected renewal.

3. Un-availed portion of Cash Credit Over-draft: In the advances portfolio of

Indian commercial banks, around 40% in the year 2004-05 (IBA,2005) advances

are in the form of cash credit and over-draft. In case of such loans, a limit is

sanctioned for the borrower, but how much and when to borrow is left to his/her

discretion. This causes a lot of uncertainty to the bank as they can neither keep

unutilized portions idle as returns may suffer, nor can they deploy them in other

assets as borrower may demand funds unexpectedly. Hence it is necessary to study

the behavioural pattern over a time period for proper handling of the same.

4. Off-balance sheet items: Items like letter of credit, bank guarantee, etc arc non-

funded commitments till the time they are invoked by the borrower to whom they

were issued by the bank. Hence, analysis of timing and the magnitude of invoking

is extremely important in order to know the impact on liquidity position.

5. Embedded options: Many items in the balance sheet that are offered to the

customers have embedded options in them. An option is a buyer's right to buy (call

option) or right to sell (put option) an item at a price determined at the time of

entering into options contract, e.g. a term deposit holder has a right to prematurely

terminate his deposit at any time (particularly when the interest rates are rising).

This causes an impact on liquidity position of the bank. Similarly a borrower may

exercise a 'call' option by pre-paying his term loan fully or partially when rates are

falling. If a customer exercises an option either on the liability side or on the asset

side with the same bank at new rates, it may not have an impact on the existing

liquidity of the bank. However, if he uses options and enters into a contract with

other bank it affects liquidity position of the bank. This calls for careful analysis of

options both on asset and liability side and their impact on liquidity position of a

bank.

6. Static and dynamic nature of the gap report: It is important for a bank to process

the liquidity report without any time delay. If there is a delay, then the few early

buckets of information would be useless as the period for which they are calculated

would have elapsed. Also, the dynamic nature of business where lot of assets and

liabilities are contracted on continuous basis make the gap report less relevant even

if taken on time. Hence it is necessary to study the potential new business and

behavioural pattern of customers.

2.3.1.2 Structural Ratios

The Structural balance sheet ratios are also used to assess the liquidity position. Some of

them are given below:

• The ratio of core deposits to core assets: It indicates the extent to which retail

deposits arc used to fund core assets such as loans and approved secunties

• The ratio of liquid assets to total assets: It is used to determine asset liquidity

• The ratio of liquid assets to deposits: It indicates the extent of Hquid assets available

to meet cash outflows of deposits in abnormal situation

• The ratio of liquid securities to total investments: It is used to determine the extent

of liquid securities in the investment portfolio which is otherwise illiquid.

From the above discussion it is evident that the bank must have proper information system

to carry out liquidity analysis. "A bank must have adequate information systems for

measuring, monitoring, controlling and reporting liquidity risk. Reports should be

provided on a timely basis to the bank's board of directors, senior management and other

appropriate personnel." (BCBS, 2000a). It is also important for a bank to analyse liquidity

under "what i f scenarios so as to assess any significant positive/negative liquidity swings

that could occur under bank-specific and market-affected scenario.

2.3.2 Interest Rate Risk Management in the Banking Book

"Interest Rate Risk is the risk of loss to the Institution in the event of changes in interest

rates, aggregated across all on-balance-sheet and off-balance sheet positions, but excluding

any positions subject to market risk" (Quemard, Golitin, 2005). In practice, banks

distinguish clearly between interest rate risk (IRR) in the trading book and IRR in the

banking book. Interest rate risk in the banking book is traditionally managed by the Asset-

Liability Management function of the bank.

As indicated before, with the deregulation of interest rates, volatility of interest rate has

increased considerably. This calls for careful planning and choosing assets and liabilities

for achieving targets of profitability.

Let us consider a situation where a bank is funding five year fixed rate loan with a one-year

fixed-rate deposit. It is exposed to IRR as the timing of re-pricing of assets and liabilities

are different. To expand the concept further, if the interest rate goes up in one year, the

bank will suffer due to decrease in interest margin. This is because the asset rate in above

example is fixed for next 5 years whereas^siTl^ the liability is maturing at the end of one

year, hence the bank will have to look for new liability at a higher rate. The concept of re­

pricing is extremely important in IRR management which indicates the time remainmg for

interest rate to change on assets or liabilities.

The second situation of IRR arises when variable-rate assets and liabilities are indexed on

two different market rates, or on same market rate but at different re-pricing dates (basis

risk as discussed below).

The third source of IRR would be when the holder (customer) exercises an option. An

option gives its holder the right (but not the obligation) to buy or sell a financial contract

which will modify the cash flow it generates.

Thus, it is necessary to analyze the IRR in the banking book and assess the challenges

faced by the banks in this regard.

2.3.2.1 The Approaches to IRR Management

IRR in banking book covers all the assets and liabilities except the trading portfolio. The

management of IRR aims at capturing the risks arising from the maturity and re-pricing

mismatches and is measured using two approaches,

A. Earning approach or accounting approach

B. Economic value or market value approach

A. The Earning Approach (Accounting Approach)

The main focus of this approach is on the impact of interest rate changes on assets and

liabilities on the net interest income (Nil) and it is one of the top order performance

indicators of a bank. Nil can be expressed as,

Net Interest Income = Interest Earnings - Interest Expenses

where interest income includes income from advances and investment portfolios excluding

any fee-based income, commission, brokerage, etc. The interest expenses include interest

paid on deposits, borrowings and debt capital of banks.

In monetary terms. Nil can be expressed as a percentage in the form of Net Interest Margin

(NIM) where,

MM = Nil / Total Assets, or,

NIM = Nil / Eammg Assets

The earnings approach has a short-term focus because the analysis of interest rate impact is

restricted to a maximum period of one year (due to one year accounting cycle). In reality,

the impact is analyzed for a quarter or a month or a shorter period depending on the

penodicity of the updation of data at the bank level.

The important tool to implement earning approach of IRR is again the gap analysis as in

the case of liquidity report. The main difference between the two, is in the gap report of

interest rate sensitivity, the assets and liabilities are placed in the re-pricing buckets on the

basis of expected change in the interest rates for the assets and liabilities and not on the

basis of cash inflows and outflows as in the case of liquidity gap report (convention

followed in this context is 'maturity date or re-pricing date whichever is earlier'). As per

the RBI guideline following buckets are prescribed for regulatory reporting,

1-28D 29D-3M 3-6M 6M-1Y 1-3Y 3-5Y Over 5Y Non-Sensitive

( D: Day, M: Month, Y: Year)

As it can be seen, the first two buckets (in the earlier liquidity gap statement) have been

clubbed and a column for 'Non-sensitive' has been added. Cash in hand can be a non-

sensitive component as it does not earn any interest and hence any change in rate would not

have any impact on cash. On the liability side the equity capital falls under non-sensitive

item as equity itself is not directly sensitive to interest rate changes, its sensitivity is

reflected through assets and liabilities.

Let us consider the following example of gap summary. As it can be seen the gap is

positive in the first re-pricing bucket and it is negative everywhere else except in the last

bucket. To carry out Nil impact analysis following formula is used,

Impact on Nil = Gap * Interest Rate Change

Rate Sensitive Gap Summary (Rs. In Crores)

Net Gap

1-28D

50

29D-3M

-1000

3-6M

-300

6M-1Y

-1500

1-3Y

-2500

3-5Y

-4000

Over 5Y

5000

Non-Sensitive

-2000

Table 2.2

25

The formula assumes that the impact is for one year period and the rate of change is per

annum. Impact for shorter period can be computed by suitably adjusting both the period of

the impact and the rate to reflect the period, .e.g. if rate changes by 1% what will be the

annual impact of the positive gap in the first re-pricing bucket? For this, we need to assume

that the timing of rate change takes place at the mid-point of the bucket, i.e. 15 days from

today. (0.5 month in this case). Thus, the impact would be calculated as follows,

Annual impact would be for the period for (12-0.5) = 11.5 months

Gap in the first bucket = 50 Crores

Nil Impact for the first bucket = Gap * periodicity of annual impact * rate change

= 50*11.5*(1%/12) = .4792

Hence, the annual impact of the rate going up by 1% on the first re-pricing bucket is Rs.

0.4792 Crores. Going by the same method, the impact of 1% rate change on the second

bucket would be, (-1000*10months*l%/12) = -8.33 crores. These figures lead to a

conclusion that Nil would suffer if the rate increases and the gap is negative (in the second

bucket) whereas the positive gap would produce positive impact on Nil (in the first

bucket). All such possible scenarios can be summarized in the following table:

Nil Impact Analysis

Re-pricing Gap

+ve (RSA >RSL)

+ve(RSA>RSL)

-ve(RSA<RSL)

-ve(RSA<RSL)

Zero (RSA=RSL)

Change in Rate

Up

Down

Up

Down

Up or Down

Impact on Nil

Positive

Negative

Negative

Positive

Zero

Table 2.3

Thus, the Nil sensitivity analysis as discussed above is done on the basis of rate sensitive

gap report to assess the impact of rate changes on the Nil for various periods. Analyst,

however, has to keep in mind some of the basic assumptions in the above computation

process such as,

i) Simultaneity in the pricing of assets and liabilities

ii) Mid-point assumption

iii) Equal change in the rates both for assets and liabilities

iv) Mispriced maturing assets and liabilities

The main advantage of this approach described by Saunders (2001) is its information value

and its simplicity in arriving at bank's net interest income exposure to interest rate changes

in different maturity periods. However, the important limitation to this approach is that, it

ignores market value effects. This is because, in this approach asset and liability values are

reported at their historical values or costs. Thus change in interest rate affects only current

interest income or expenses. As observed by Hudson (2000), this approach only shows

how interest rates will affect the assets and liabilities but not by how much. A number of

banks (particularly small banks) in India have so far limited their IRR management to

earning approach, but it has a short-term focus and covers only initial part of the life of

assets and liabilities in the balance sheet. However, RBI has also advised the banks to

move ahead and adopt 'Duration' based approach. (RBI, 1999b)

One more limitation to the earnings approach is though higher earnings indicate higher

profit they are not adjusted to risk. Higher profits may not mean better performance unless

the risk taken for attaining the performance is taken into consideration.

B. Economic Value or Market Value Approach

A better approach than Earnings approach is Economic Value Approach (EVA) that covers

long-term implications of changes in interest rates by covering the entire lifespan of assets

and liabilities. The need to graduate to EVE approach has recently been amply highlighted

in a research study (Saha, Subramanian, 2004) in which the researchers have reported the

potential net worth exposures of major banks in the country due to volatilities in the

interest rates during the recent years. Following table shows the EVE impact where the

authors have generated 1000 simulated interest rate changes to calculate the impact on

EVE of 11 public sector banks in the country.

27

EVE impact as % of Market Value of Rate Sensitive Assets

Year Bank Banki Bank2 Bank3 Bank4 Banks Banks Bank? Banks Bank9 Banki0 Banki1

2002

-5.301 -8.454 -6.704 -3.149 -3.941 -7.585 -5.495 -9.074

-21.344 n.a. n.a.

2003

-7.216 -9.504 -7.349 -4.24 -4.24

-11.289 -8.359

-10.701 -24.124

n.a. n.a.

2004

-7.242 -10.192 -8.749 -8.749 -4.664

-11.575 -9.577

-13.023 n.a.

-7.076 -14.069

(source: Salia, Subramanian. 2004)

Table 2.4

Under this approach, the impact of rate changes are studied on an important variable called

Economic Value of Equity (EVE), where,

EVE = Economic Value of Assets - Economic Value of Liabilities (except equity)

EVE reflects the future earning potential of a bank (Saha, Subramanian, 2004). EVE

approach considers the fact that changes in interest rates not only change the Net Interest

Income, but also economic value of assets and liabilities, which in turn is reflected in the

value of equity.

This approach is based on the valuation of each rate sensitive asset and liability which is

known as 'present value of future cash flows' in the subject of finance. Here the basic

principle is when the interest rate increases, the value of an asset would fall and vice versa.

This applies to liabilities also; however, when the value of an asset goes up, it has a

positive impact on EVE while if value of liability goes up, it has a negative impact on

EVE.

One more reason because of which this approach has gained prominence is that for a given

change in interest rate the change in Nil and the change in EVE need not be in the same

direction. It is possible that when the rate goes up, bank significantly gains in terms of Nil,

but it faces the reduction in EVE and vice versa. Thus, it is a challenging situation for

bank management to manage both Nil & EVE simultaneously. They are required to set-up

limits for both Nil & EVE and ensure that the actual impact is within prescribed limits.

2.3.2.2 Duration: A Measure of an Asset or Liability's Rate Sensitivity

Duration is a more complete tool to calculate an asset or liability's sensitivity than the gap

model discussed earlier. According to Hempel and Simonson (1999) the matching gap

attempts to stabilize earnings, while matching duration attempts to stabilize Net-worth

value of the portfolio.

Duration Computation Principal Open_date Current Date Maturity Date Interest Rate at contract Freq of interest Payment Current Rate of Interest Residual Maturity (Years)

Time Period (t) in years

Value of Deposit

50000 01/01/2004 01/01/2005 31/12/2009

9% 1

8% 5

1 2 3 4 5

Cash Flow

4500 4500 4500 4500

54500

PVCF

4166.67 3858.02 3572.25 3307.63

37091.78 _^51996.4

Duration Segment

0.0801 0.1484 0.2061 0.2545 3.5668 4.2559

3.9406

-*—

<—

Duration

Modified Duration

Table 2.5

The concept of duration analysis is based on Macaulay's concept of 'duration'. Let us

consider the example in Table 2.5 to understand how duration is computed. The valuation

in the table is carried out for term deposits which states that the economic value of the

deposit is Rs.51996.4 whereas the book value of the same is Rs.50000. A higher economic

29

value than the book value for a liability in this case is a negative impact on EVE. This

indicates possible deterioration in the future earning potential of the bank. Though the

market rate has fallen to 8%, the bank cannot reduce it as the deposit carries a fixed rate.

Hence the reduction in EVE for Rs. 1996.4 (i.e. 50000-51996.4) indicates the present value

of future losses. The bank will suffer from this for 5 years of life of deposit as it is forced

to pay 1% more than the present interest rate. Also, in this situation it is unlikely that the

depositor will exercise the 'put' option to prematurely withdraw his deposit as he would

lose the benefit of higher rate.

Both the duration and modified duration are interpreted to assess the volatility of the value

of deposit for a change in interest rate. Traditionally duration is the pay-back period by

which the investor would get back the original amount invested along with the expected

return. The duration number 4.25 for the deposit is the pay-back period in years for the

depositor. In the IRR context, duration is a measure of interest rate sensitivity applicable

in the continuous compounded form of interest rate. Technically, duration is the time-

weighted present value of a financial institute's cash flows. (Sinkey, 2002 : 664) The

higher the duration value, the more sensitive is the price of an asset or liability to changes

(or shocks) in interest rates. The modified duration gives the percentage change in the

price of asset (or liability) for a 1% change in its rate. e.g. modified duration of number

3.94 suggests that with 1% change in the interest rate of deposit, the value of the deposit

would change in the opposite direction by 3.94%.

In the above manner, the duration is found out for each asset and liability in the balance

sheet to arrive at the aggregate level duration. The aggregated duration of assets (or

liabilities) is nothing but the weighted average of individual asset (or liability) durations

where the weights used are market value of each asset (or liability) to the total value of the

assets portfolio. Once the assets and liability durations are estimated, they need to be

compared with each other to find out the net sensitivity which would impact the equity.

Consider this example,

30

Duration of assets = 4.5 Value of asset = 100

Duration of liabilities = 3 Value of liabilities = 85

Duration Gap = (4.5-3) = 1.5

Economic value of equity = (100-85) = 15

When the duration of assets exceeds the duration of liabilities the duration gap is positive.

A positive duration gap means greater exposure to rising interest rates; if interest rates go

up then the price of assets fall more than the price of liabilities and as a result EVE would

fall from its present value of Rs.l5. (Conversely, when the duration gap is negative; if

interest rates fall then the price of assets goes up less than the price of liabilities.)

One more factor that needs to be considered here is that, some portion of the assets is

funded by outside liability which is an adjustment for leverage, where

Leverage = 80/100 = 0.8 and,

Leverage adjusted duration gap = 4.5 - (3*0.85) = 1.95

Since the gap is positive, if interest rate goes up, there will be reduction in EVE and if it

falls, EVE would increase. The impact analysis of rate change on EVE is summarized in

following table:

Impact of rate change on EVE

Duration Gap

Positive

Positive

Negative

Negative

Zero

Interest Rate Change

Goes Up

Comes Down

Goes Up

Comes Down

Up or Down

EVE Impact

Negative

Positive

Positive

Negative

Zero

Table 2.6

To compute the impact on EVE following method is used:

Impact on EVE = -Duration gap * Economic value of asset * interest rate shock

where shock= change in rate/(l+new rate)

If the cun'ent rate is 9% and it increases by 1% in the above case, EVE impact would be,

-1.95*I00*(1%/(1+10%)) = -1.7727

Hence, EVE after shock = 15 - 1.7727= 13.227

Thus 1% increase in rate has caused negative impact on the EVE. Opposite would be the

case if the rate goes down by 1%.

To conclude IRR management under EVA approach, it can be stated that there are three

major components in IRR management viz., (Leverage Adjusted) Duration Gap, Market

Value of Assets and Interest Rate Shocks. Out of these three, the third component is

beyond the control of a bank. However, by adopting suitable policy, banks can sustain the

impact of adverse changes in interest rate by controlling market value of assets and

duration gap. Increase in duration gap is possible by either increasing asset duration or

decreasing liability duration or reverse actions would reduce the maturity structure of

assets and liabilities and consequently the duration gap.

2.3.2.3 Special Issues in IRR

For duration analysis, it is assumed that the interest rate for all maturities are same or in

other words, the yield curve* is assumed to be flat. However, in reality slope of the yield

curve may fluctuate with change in interest rates. Hence following additional risks also

need to

be considered.

Yield Curve Risk : Yield curve risk arises from variations in the movement of interest

rates across the maturity spectrum. It involves changes in the relationship between interest

rates of different maturities of the same index or market. (E.g. 5-year deposit rate may go

up by 1% whereas 3-year deposit rate may go up by 0.5%.) These relationships change

*Yield Curve is a graphic line chart that shows interest rates at specific point for all securities having equal

risk but different maturity dates.

32

when the slope of the yield curve steepens, or become inverted. Yield curve variation

highlights the risk of a bank's position by magnifying the effect of re-pricing mismatches.

The extent to which a bank is mismatched along the term structure will increase its

exposure to yield curve risks.

Basis Risk; Basis risk deals with the correlation between two different rates. It arises from

the non-parallel responses in the adjustment of interest rates among two or more rate

indices or "bases" i.e. when changes in asset rate and liability rate are not happening by

same magnitude. Basis risk also includes changes in the relationship between administered

rates, or rates established by the banks, and external rates. E.g. it may occur when there is a

difference in prime rate and bank's offered rate

Options Risk; Options risk arises when a bank's customer has the right (not the

obligation) to alter the level and timing of cash flows of an asset or a liability. An option

gives the owner the right to buy (call option) or to sell (put option) a financial instrument at

a specified price (strike price) over a specified time period. For the seller of an option, (e.g.

a bank) there is an obligation to perform if the owner exercises his option. Generally owner

will exercise his/her right when it is beneficial to him/her. Thus, the owner faces limited

downside risk and theoretically unlimited upside reward. For the other party (i.e. a bank)

the situation is exactly opposite. All the banks have some degree of option exposure. For

instance, on the assets side a common problem is of prepayments when interest rate

decreases. Actually, in this situation, the bank would prefer the borrowers maintain their

outstanding balance and pay at higher contracted rates. However, higher cash-inflows due

to prepayments force the bank to reinvest the funds at lower rates. This is known as

'reinvestment risk\ Conversely, when interest rate increases customers would like to delay

payments and bank consequently would lose the opportunity of investing the principal in

new higher yielding assets. This slowdown in prepayment is also known as extension risk.

On the deposit side, the most common option given to the customer is a right to withdraw

prematurely. When the rate increases and the market value of the customer's deposit

decreases he/she has a right to exercise 'put' option and re-invest elsewhere yielding higher

returns.

:̂ 3

2.4 Role of IT in ALM

Recognizing the need for a strong and sound information system for ALM, the Reserve

Bank of India has issued the ALM guidelines in February 1999. The guidehnes have

emphasized that each bank must have an Asset-Liabihty Management Committee

consisting of senior management which is responsible for balance sheet planning from a

risk return perspective including management of interest rate risk and liquidity risk. Also,

the RBI has expressed the need to have sound information system for ALM. "The central

element for the entire ALM exercise is the availability of adequate and accurate

information with expedience." (RBI, 1999a) However, many Indian banks are not in a

position to generate the required information on ALM. The biggest problem faced by them

is collecting accurate data in timely manner due to wide geographic spread of branches and

lack of computerization. In many banks in computerized branches the software vendors

have provided the facility to generate ALM information mandated by the regulators.

However, mostly this information is limited to Liquidity Gap statement or Rate sensitivity

Statement. Given this background, it was decided to develop a comprehensive information

system on Asset-Liability Management that would address the issues discussed above.

2.5 Computer based ALM System

The information system for ALM can be divided into two subsystems,

Part I: The first system that operates at Regional or Zonal Offices of the bank which

mainly focuses on liquidity gap and interest rate sensitivity reports. The output of such

systems working at all Regional Offices (ROs) /Zonal Offices (ZOs) will be

consolidated at Head Office to take a final view.

Part II : The second system which works only at the Head Office and which mainly

handles techniques of Interest Rate Risk Management.

2.5,1 Part I: Liquidity Gap Analysis

The main purpose of having this system is to generate liquidity gap report and for

measuring short-term liquidity risk by placing assets and liabilities into various timc-

34

buckets on the basis of their respective maturities. A significant portion of data that is

needed to generate this kind of information needs to be captured from the bank's day-to­

day operational systems. Particularly, in case of term deposits and term loans, the bank is

required to capture account level information of each of the deposit and loan account.

Considering the volume of this data, processing it manually would not only be difficult for

banks but also prone to errors reflecting the wrong picture to the top management. One

more issue is that, such data does not remain static (as the business keeps "rolling in and

out") with passing of time and banks are required to take a view at a certain frequency.

A computer-based information system would certainly help in this situation which can not

only help the banks in meeting their compliance requirements but also in generating other

useful information which would help them in product planning and related exercises.

2.5.1.1 Methodology

In order to develop the information system for asset-liability management the steps

described below were followed:

1. Finding sources of data: Those items in the balance sheet which have definite

contractual period were considered as the main source for the system. Such items

include term deposits (cumulative, non-cumulative, recurring) and term loans

(PLR* linked and non-PLR linked). As shown in the Figure 2.1, both term loans

and term deposits data originate at branch level. In a computerized branch it is

maintained by the branch automation software, whereas in a manual branch clerks

maintain it in manual ledgers.

2. Master and Incremental Data Creation: The next step was to collect the data at

one place for further processing. Many public sector banks in India have not yet

achieved 100% branch-computerization and hence the entire data are not available

in electronic format. For manual branches, it was decided that they would send the

data to Regional or Zonal Offices (RO/ZO) in a paper format. At this level, the data

entry facility was provided to the users so that the data from manual branches

would be added into the main system. For computerized branches it was decided

*PLR: Prime Lending Rate, the loan interest rate that bank uses as a base to calculate interest rates.

35

;Branch

Submit A/c level Data

Data Correction

:RO/ZO

Receive A/c level Data

Processing and Consolidation of A/c. level Data

Send Back

Check Error

z, X Report

Generation Send Aggre­

gate Data

HO

Receive Data

Consolidate all ZO/RO

Report Generation

•®

Figure 2.1: An activity Diagram for Initial Data Consolidation of ALM Process

36

that they would send the data in electronic format to RO/ZO. At RO/ZO level, a

facility was provided to import this data in the integrated ALM database.

Considering the volume of data, it was decided to use Oracle Relational Database

Management System. In this way master data was created in all the regions as one­

time exercise.

However, as indicated earlier in the discussion of liquidity gap analysis, it is

necessary for a bank to conduct detailed study of roll-in, and roll-outs. For carrying

out this analysis, it was necessary to capture details of transactions at a certain

frequency. Such transaction data would include, details of newly opened deposit

accounts, accounts closed, accounts prematurely closed, accounts prematurely

closed and renewed, accounts matured and renewed. In case of term loans, the

transaction data consists of newly opened accounts, accounts closed, accounts pre­

paid and closed, installments paid, interest applied and other charges applied, if

any. A unique transaction flag was identified for all such transactions using which

master data could be updated, (e.g. 'N': New account, ' C : Close account, etc.)

3. Updating Master Data: The next step was to develop the necessary software

programs to update the master data with transactions. As shown in the Figure 2.2,

using transaction data master data was updated. In case, if any error (such as

duplicate record) was found in the transaction, a report was generated for further

action.

4. Interest Provisioning: In case of non-cumulative deposits, interest is paid to the

customer on monthly/quarterly/half-yearly or yearly basis. For cumulative and

recurring deposits interest is paid only at the maturity of the same. However, for

such accounts banks need to do interest provisioning on half-yearly basis. Such

interest provisioning would update the outstanding balance of deposit accounts by

the respective interest amounts. Considering this, a program was developed to do

interest provisioning on deposit accounts.

5. Treatment of 'Non-Maturity' Items: As indicated earlier, the 'non-maturity'

items in the balance sheet can result in cash flow at any time and hence it is difficult

to place them in a definite bucket. Hence, after going through RBI guidehnes, it

was decided to study their behavioural maturity on the basis of statistical analysis

37

Branch

Submit trans­action Data

Data Correction

:RO/ZO

Receive Data

Uodate master data

Send Back

Check Error

Consolidate Updated Master

Report Generation

Figure 2.2: An activity diagram for updating the master data with the incremental data

38

and then place them in appropriate time buci<.et. This was done by developing a

small module on Trend Analysis. The module takes weekly (or fortnightly or

monthly) data of non-maturity assets and liabilities. All such assets would include

demand loan, CC/OD BP/BD and other advances and the liabilities would mainly

include current and savings deposit. Based on historical data it performs trend

analysis to forecast the future values based on the concept of i) simple polynomial

regression up to degree 15 or ii) moving averages up to 25 periods.

6. Report Generation: More than 25 reports were generated from the system

including the reports required for compliance purposes. Some of them are discussed

in detail subsequently. A facility was given also to export these reports so that the

same would get imported at the Head Office level.

2.5.1.2 Issues Faced during the Implementation

Similar to any other software development project, in this work also many practical

difficulties were faced. The major implemented issues are described below:

1. Data consolidation of manual branches: In case of manual branches, the biggest

problem was how to minimize time-delays in sending and receiving the data. To

start on an experimental basis, few manual branches (with higher business volumes)

were short-listed for the whole exercise. A Foxpro-based data-entry module was

provided to some branches, which were having a personal computer. The bank

decided to extend the same facility to the remaining manual branches over a period

of time.

2. Ddata consolidation of computerized branches: The public sector banks where

the system was implemented had the following problems as far as their

computerized branches were concerned:

i) Heterogeneity in the platforms: The banks were using different branch

automation software supplied by more than 6-7 vendors. Typically,

these vendors used varied platforms such as Oracle/Unix,

COBOL/Btrieve/Novell Netware,etc.

39

ii) Non-availability of data in required format: Particularly, getting

incremental data in required format (with 'flags' as described above)

from computerized branches was difficult.

In order to overcome this problem, all the three parties including the bank and the

vendors held the discussions and came to the agreement that the vendors would

provide a small data extraction utility which would extract the necessary data in

'text format'. Each vendor's data structure was stored in the ALM system.

Subsequently, the 'import' utility was added in the system to add the text data to

Oracle based ALM database repository. After reading the data in text format this

utility would identify the 'branch code' of data to be imported, find out the

respective vendor code and accordingly map the data to required format. This

facilitated import of branch data irrespective of the platform on which branch

software would use. " T n " 'jjO'l *§ 3

3. The issues in incremental data: Similar problem was faced in case of incremental

data which was resolved as in the case of master data. The vendors were also asked

to include transaction 'flags' in the data extraction utility of transaction data.

4. Integrating new products: Next major concern was how to integrate new products

with the existing system, i.e. if bank adds new deposit scheme, it should be possible

to define the same in the system. The database was designed in such a way that all

product definitions were maintained in a separate table. This table stored the

characteristics of products such as type of deposit (Cumulative, non-cumulative,

recurring), details of interest computation, interest payment frequency, etc. Due to

this, it was possible to add new product scheme whenever bank launched the same.

5. Processing time: The main purpose of the system was to generate reports. The

entire data processing that was needed for report preparation was done at the time

of data import, e.g. when the new records are added, the system would generate

report related information like, bucket_index, sizejndex, contract_period_index,

overdue_index, etc. and the same would be stored in the deposit table along with

each record. The necessary logic to generate this information was written in the

back-end PL/SQL (procedural language of Oracle) which would be executed only

when data is imported or processing date is altered by the user. This improved the

40

speed of report generation to a great extent as against those systems which use

front-end logic for generating reports.

6, Additional Queries: As indicated earlier the system was installed at RO/ZO of the

bank. However, sometimes branches need some information. Particularly manual

branches may want to know about interest provisioning held in their accounts, etc.

Considering this, a facility was given to build additional queries using a query

builder.

2.5.1.3 Important Output Reports of the system*

1. Schemewise Overdue Deposits

As per RBI guidelines entire amount of overdue deposits should appear in the first

bucket of liquidity and rate sensitivity reports. However, if the deposits remain overdue

for long time, the bank may like to distribute this amount over a number of buckets.

This report shows the distribution of overdue deposits in various time- buckets based

on the past dates. This will explain the managers how long deposit amount has been

overdue with the bank.

2. Scheme wise Remaining Term to Maturity (Outstanding Amount) for Term Deposits

This report reflects the contribution of term deposits (scheme wise) to overall liquidity

and rate sensitivity of the bank's balance sheet. By looking at this report, the quantum

of deposits maturing in various time buckets can be understood.

This will help the bank in formulating a policy on funding medium to long term assets

using these deposits.

3. Draw Down Profile of Deposits

In this report residual maturity is shown as against contractual period of deposits. These

reports reflect the draw down profile of the term deposits of the bank. The tenure

structure of maturing deposits can be viewed from these reports. For example, out of

Rs.500 crores of deposits maturity in the first bucket, deposits to the tune of Rs.251

* Sample Output reports are enclosed in Annexure B

41

crores are from 1 - 3 year deposits. This will help the bank in planning its deposit

profile.

4. Interest-provision Held

The scheme wise interest provision held in the cumulative/recurring deposit accounts is

reflected in this report. This report helps the bank to understand the magnitude of rate

sensitivity as a result of provision of interest to cumulative deposit accounts (of the two

rate sensitivity components, interest on principal and interest on interest, the second

part can be analysed through this report).

5. Interest-provision to be Made

This report reflects the interest provisions to be made schemewise in future on the basis

of existing balances and rates. This will help the bank in profit planning exercise. The

amount of interest provision to be made will also be reflected in the dynamic liquidity

statement.

6. Interest-Rate wise / Rate Range wise Remaining Term to Maturity

These reports help the bank in analysing the rate range of deposits. This along with the

maturity composition of the deposits enables the bank to take a view on alignment of

the deposit rates vis-a-vis existing market rate on deposits. Any misalignment in

favour of the bank may trigger the depositors' exercising their option to prematurely

close and extend the deposits. The bank has to analyse very carefully the report to get

valuable information on the impact on the optionality and on the profitability in various

rate scenarios.

Any bunching of a particular (favourable or unfavourable) rate range can also be

analyzed through these reports.

7. Deposit-Size wise Distribution of Deposits

The rate range wise contribution of deposits of various sizes to total deposits can be

analyzed through the report. This will enable the bank to study the composition of

retail and wholesale deposits and its conditioning.

42

8. Premature Closing and Renewal of Deposits

i) A two-way table showing deposits' old rate of interest before renewal

and new rate after renewal.

ii) A two-way table showing deposits' old contract period before renewal

and new contract period after renewal.

The rate wise transition report is significant in highlighting the rate responsiveness of

the depositors of the bank to interest rate changes. Studying these reports over a period

of time will enable the bank to fine-tune its deposit rate decisions. This will also

enable the bank to study region-wise (or zone-wise) rate sensitivity and exploit the

same to its advantage. For example, in a low rate sensitive region (zone), the bank may

target higher volume of deposit mobilisation.

The period wise transition report can indicate the structural shifts in the liability

compositions in the balance sheet.

9. Remaining Term to Maturity for Term Loans

i) Scheme wise Remaining Term to Maturity (Principal Amount) of PLR

Linked Loan

ii) Scheme wise Remaining Term to Maturity (Principal Amount) of Fixed

Rate Loans

iii) Scheme wise Remaining Term to Maturity (Outstanding Amount) of Term

Loans

The scheme wise contribution of term loans to liquidity and rate sensitivity of the bank

is reflected in these reports. In case of Liquidity Report, the amounts in various

buckets in the third report needs to be considered on the basis of remaining term to

maturity. But for Rate Sensitivity Report, while the fixed rate term loans will be

reflected on the basis of remaining term to maturity, the PLR linked loans will appear

on the basis of expected re-pricing date or term to maturity whichever is earlier.

43

10. Rate Range wise Remaining Term to Maturity for Term Loans

These reports help the bank in analyzing the rate range of term loans. This along with

the maturity composition of the loans will enable the bank to take a view on alignment

of the loans vis-a-vis existing market rate. Any misalignment in favour of the bank may

trigger the borrowers' exercising their option to prematurely close and renegotiate the

loans. The bank has to very carefully analyze the report to get valuable information on

the impact on optionality on profitability in various rate scenarios.

11. Roll-in / Roll-out of Deposits / Loans

These two reports give the summarized picture of overall business related to term

deposits and term loans. Using these reports bank can see in a given time-period the

extent of closure, premature closures, renewals, premature renewals and new business

added.

12. Contractual Maturity of Term Deposits and Term Loans

This report when consolidated for bank-level, will help the bank in formulating their

Fund Transfer Pricing policy.

Thus, the above approach of 'Liquidity Gap Analysis' helps the banks to see the

mismatches of their cash outflows and inflows. While the mismatches up to 1 year are

relevant since they provide early warning signals of impending liquidity problems, the

main focus should be on short term mismatches viz. 1-14 days, 15-28 days.

44

2.5.2 Part II : Managing Interest Rate Risk

Although IRR and hquidity risk occur at branches of a bank in the process of their

intermediation between depositors and borrowers, these risks need to be brought together

at the highest level and managed. The reason is "these risks arising at a branch is not

relevant as they can be offset by exactly opposite positions in some other branch of the

same bank" (Subramanian, 2004:3). Hence, the analysis of IRR needs to be carried out at

the bank level as a whole.

Keeping this in mind, a separate module was developed to handle IRR management which

mainly handles following activities.

1) Impact Analysis (Earning Approach)

2) Computation of Duration, Yield-curve risk, basis risk and options risk (EVE

Approach)

The module would function at the head office levels. The following write-up discusses the

methodology followed in the development of this module.

2.5.2.1 Methodology for Earnings Approach

1. As shown in the Figure 2.3, the bucketed data for term deposits and term loans

would be sent to the Head Office. (The alternative approach is to generate bucket-

wise cash-flows at the HO level. However, this approach is feasible only if, the HO

is equipped to process the data in terms of hardware/memory requirements.) For

other items which are of non-maturity variety, the head office would create its

bucketed information based on the behavioural method discussed earlier.

2. Based on the above data, the system would first compute the gap statement and

cumulative gap statement.

45

;RO/ZO

Submit bucketed data

for Term Deposit/Loan

:HO

^ > Receive

Data

• "

Consolidate for all RO/ZO

^ f

Add Bucketed data for non-

maturity items

Generate Gap statement

Nil impact Analysis

J

1 r / >

Report Gen ;ration

Duration & EVE Analysis

^ )

1 r C -N

Report Genert ition

Figure 2.3: An Activity Diagram for Nil Impact and Duration Analysis

46

3. A facility to study an impact on Net Interest Income (Nil) in case of interest rale

change is given to the user. It includes following options:

(i) Asset rate goes up /down by how many basis points*

(ii) Liability rate goes up /down by how many basis points

These two possibilities can be studied for the following scenarios,

(i) Rate changes at the midpoint of the bucket

(ii) Rate changes at the beginning of the bucket

(iii) Rate changes at the end of the bucket

(iv) Rate changes at the end of the bucket

(v) Asset Rate changes at the beginning and Liability rate at the end of the

bucket

(vi) Asset Rate changes at the end and Liability rate at the beginning of the

bucket.

2.5,2.2 Methodology for EVE Approach

In order to implement this approach also, the head office would use bucketed data for term

deposits and term loans. Additionally, HO would need to provide interest rates for assets

and liabilities for various buckets,

For a given reporting date the following analysis can be carried out at HO level,

1. Computation of Market value of assets and liabilities in each bucket and the totals.

2. Duration Gap and EVE Sensitivity Analysis : This report will give durations of

assets and liabilities in each bucket, the duration gap and for a given change in

interest rate, it will compute effect on the EVE i.e. for a given rate change how

much value will go up or down.

"Basis Point : One hundredth of one percent, i.e. 100 basis points = 1 percent

47

3. Basis Risk : This report will accept from user the change in asset rate and change in

liability rate and it will compute impact on assets, liabilities and net impact

4. Yield Curve and Basis Risk: This report expects that there will be non-uniform

changes in each bucket and hence user will be asked to enter the same for either

assets or liabilities, e.g. if the user enters such rates for liabilities, the same would

be treated as independent variable. From this, to find out the asset rate (dependent

variable), it is necessary to find the slope of the yield curve. The same can be found

out by studying the historical movements of rate changes. Once the user enters

independent rate and the slope coefficient, user can see the net impact on EVE.

5. Options Risk: This requires the % of premature closures and renewals (in case of

term deposits) which can be obtained from one of the reports discussed earlier. The

above four reports can be re-done incorporating this percentage.

2,6 Advantages of Computer Based ALM System

The advantages of the said system are as follows:

1. Data Accuracy: Data accuracy begins with data input. The said system requires

least amount of manual entry as data is extracted from branch level automation

system in a text format and then it is imported using a conversion module. Also,

required data entry module for manual branches includes stringent field level and

record level validation checks to avoid data entry errors.

2. Data Integrity: The integrity of data is ensured through exceptional error

reporting. Particularly, for transaction data, exception reports can throw the

information on duplicate accounts, missing master account, etc. Also, when the

master data is updated at a certain periodicity, system ensures that updates are

taking place in chronological order of dates.

3. Reporting and Analysis: The computer based information systems for ALM can

not only produce the reports discussed above, but it also provides a facility to user

to perform ad-hoc analysis by writing his own queries through a query builder. The

system includes more than 20 pre-defined queries and a query builder.

48

2.7 CONCLUSION

Asset-Liability Management is concerned with the strategic management of balance sheet.

It is an attempt to match the assets and liabilities in terms of their maturities and interest

rate sensitivities so that risks arising from such mismatches - mainly interest rate risk and

liquidity risk - can be controlled within desired limits. The central element to the entire

exercise is the availability of adequate, accurate and timely information which demands

extensive technology support. However, most of the Public Sector Indian banks are finding

it difficult to generate this information due to wide geographic spread of branches and

heterogeneous platforms of branch computerization where the necessary data resides.

Given this background, an attempt is made to deploy technology based solution in the area

of ALM. The real merit of the system lies in the fact that it goes beyond regulatory

compliance and provides competitive advantage to banks by providing the reports that can

be used in the decision-making process of construction and modification in the balance

sheet structure in accordance with the risk appetite of individual bank on a continuous

basis.

49