The Value Of Asset Liability Management Example For Free - Free Essay Example

The Asset-Liability Management is one of the most crucial functions of a bank in the highly competitive and complex business environment today. Asset-Liability Management is a co-ordinated management of a banks balance sheet to allow for different interest rate, liquidity and optionality shocks. Post Liberalization in 1991, deregulation of various banking operations, freeing of interest rates, entry of new generation banks increasing the competition, diversifying of banking activities, integration of Indian banking into the world, introduction of new, complex products in the market, have all led to increase in the volatility in the financial market. In such a scenario, there are various opportunities, but they all come up certain risks, which if not handled carefully could wipe out a banks profits and may even result in its bankruptcy. The recent global financial crisis has further reinforced the importance of asset-liability management in banks and the current market scenario in India has meant that banks have been facing asset-liability mismatch in their balance sheets as well. The 2 major types of market risks a banks faces are Liquidity Risk and Interest Rate risks, which are primarily addressed by the Asset-Liability Management of a bank. The methods and approaches towards Asset-Liability Management have evolved over the years due to changes in the business environment and the governing body for commercial banks in India, RBI, has prescribed certain guidelines from time to time to make sure all commercial banks fall in line and follow a uniform method for the same. In its recent Monetary Policy Review, RBI expressed concern towards the current asset-liability situation in the banks and asked banks to curb their lending, which has gone well In excess of their deposits, leading to straight negative mismatch and liquidity crunch in the system. Also, the constant increases by RBI in the Repo rates (due to inflationary pressure) over the past 1 year has led to increase in cost of funds for the banks, hitting their Net Interest Margins. The banks recently have been forced to increase their deposit rates significantly to attract fresh deposits to address the liquidity problem, which will also lead to decrease in their profit margins in the ongoing and future quarters. The paper will also discuss how the Asset-Liability Management is carried out at State Bank of India, Indias largest bank. WHAT IS ASSET LIABILITY MANAGEMENT (ALM) ALM is the management of total balance sheet dynamics with regard to the size and quality. It is a process of adjusting bank liability to meet loan demands, liquidity needs and safety requirements. Asset liability management is a philosophy under which the bank can target assets growth by adjusting liabilities to suit their needs. Its focus is on Profitability Long term operating viability It is a co-ordinated management of a banks balance sheet to allow for different interest rate, liquidity and optionality shocks. It involves: On balance-sheet match of the assets and liabilities being re-priced. Off balance sheet hedging of the on balance-sheet risks. Securitization, to remove the risk from the balance sheet. Alignment of branch level targets with broader goals of bank. Centralization of liquidity and interest rate risks. It is a process to match Assets and liabilities In terms of maturities and interest rate sensitivities to minimize Interest rate r isk and liquidity risk. ALM involves Quantification of risks Conscious decision making with regard to asset liability structure in order to maximise interest earnings within the frame work of perceived risks. BENEFITS OF ALM There are various benefits of having a proper Asset-Liability Management: Awareness of various risks in the banking book, beyond credit risk. Risk appetite for the banking book and at the portfolio level is clearly defined once hidden risks are known to the bank. Strategies to manage or mitigate intermediation risks. Hedging with capital or derivatives. Enhancement of net worth. Limits based on risk/ return trade-off much larger low-risk positions can be assumed with the knowledge of ALM. Entry into lucrative high-risk businesses with the guidance of ALM, if (i) they are weakly related to the existing portfolio or (ii) bank has access to options. EVOLUTION OF ALM ALM was in response to much sharper stock market, exchange rate, price and interest rate volatility since the early 1970s. The following events led to its evolution globally: The SL crisis Savings and Loans Associations (SL) in California, USA offered LT, fixed-rate, mortgage-backed housing loans, funded by ST deposits. Money market funds offered higher deposit rates, to reduce SL deposits on a large-scale, in the 1970s. SL deposit rates were deregulated. Cost of funding went up much faster than rise in yields on advances. NII simulations showed high book value of capital decline in reported NII was gradual. Regulatory capital lowered to 3% of assets. Restrictions on SL lending lifted. Large-Scale book insolvency by mid-1980s. Lessons from SL crisis The result of high exchange rate, price and interest rate volatility. High bailout cost ($154 billion) result of regulatory laxity and political connections. Exposure to interest risk, even in the non-tradable banking book, with volatile rates. Maturity mismatch between assets and liabilities. Focus on opportunity costs even for non-tradable products, like loans, rather than their book values. Orange County Disaster Composition of Orange County Investment Pool (OCIP) in 1994: Long-term securities, with maturities between 3 and 5 years around 47%. Long-term inverse floaters, with maturities between 3 and 5 years around 33%. For an inverse floater, the coupon falls as rate rises. They were both funded by short-term deposits and repo ( 180 days) borrowing. Assumption of steady or declining rates worked till end-1993 huge NII gains and profits for OCIP. Rise in market rates Fed Funds and Long-term by 250 bps in 1994. Sharp fall in value of assets and repo collateral funding liquidity crunch. On December 1, 2004, Orange County announced a loss of USD 1.6 billion and filed for bankruptcy. The plea that Assets and Liabilities were HTM was rejected and assets liquidated at low market value. Asian Crisis Near Collapse of LTCM Sharp rise in funding costs (IRR) Þ liquidity squeeze (Funding liquidity Risk) Þ distress sales Þ collapse in Market Value of Assets and Equity (Market Risk and Asset Liquidity Risk). Failure of NII gap simulations to consider erosion in Market Value of Equity. Introduction of complex derivatives for risk reduction interdependent credit, market and ALM risk Shift to MTM valuation of Assets and Liabilities. Duration and Duration Gap analysis for sensitivity of risky and riskless cashflows. Portfolio VaR for probabilities and correlations. Emphasis on simulations and Economic Capital. Rapid decrease in the cost of computer storage capacity and sharp rise in speed and precision. Widespread use of Monte Carlo (MC) simulation. ALM MILESTONES IN INDIA Early-mid 1990s: Interest Rate deregulation. 10.2.1999: First ALM circular. Focus on funding liquidity Risk and NII Gap analysis. No discussion of Trading Book. June 2001-April 2004: Steady decline in market rates. Focus on long-term G-secs. Huge trading profits. October 2002: Market Risk Guidelines. Inclusion of Banking Book Liquidity Risk and IRR. May 2004 -: Sharp rise in rates. Huge trading losses. 24.6.2004: Market Risk Capital Charges. Shift to Duration Analysis for Trading Book. June 2004: Introduction of Basel II. Liquidity and Banking Book IRR in Pillar 2. Separation of banking and trading books. 2.9.2004: Permission to shift SLR investments, upto 25% of NDTL, to the HTM category. 17.4.2006: Draft guidelines on ALM. Focus on Duration Gap Analysis. Addition of three regulatory buckets in RSG statement. October, 2007: Revised ALM guidelines, dividing the Liquidity statements first maturity bucket into 3 buckets. IMPLEMENTATION OF ASSET-LIABILITY MANAGEMENT Organizing a Planning Team Developing a Strategic Plan Establishing an Asset Liability Committee Developing an Annual Budget or Profit Plan Developing a process for reviewing performance The Planning Team Team Usually Consists Of Staff Members Who Have Basic Skills And Knowledge And Will Be Headed By CEO. It does the following: Developing Strategic Plan Initiate planning process Assigns responsibility for developing overall plan Review the components and recommend actions to board of directors. Setting Goals For Risk Management Profit Planning The Strategic Plan This plan has 5 key components: Mission statement Strategic financial goals Situation analysis Swot analysis Action plan supported by financial plan ALCO It is the apex committee of a bank for asset-liability management. ALCO comprises staff members and the CEO. ALCO meets more frequently. ALCO develops , implements and manages banks annual budget or profit plan and risk management programme. Timely, accurate data and analysis is a must for ALCOs success Budget or Profit Plan This is a tool to keep the bank on track to achieve its strategic financial goals. ALCO helps to oversee the making of the financial budgets It makes recommendations if necessarry The ALCO considers all details like time covered by the plan , contingencies that may cause the plan to change, and the action plans, goals and timetables so as to effectively implement the plan. Review System Review helps to find out the short comings and alter it if necessary As and when the plan is written the frequency of the reviewing is also decided This helps the banks to be consistent with the banks short and long range goals. LIQUIDITY RISK MANAGEMENT IN BANKS A bank faces liquidity risks of the following types: Funding Risk It happens when there is a need to replace net outflows due to unanticipated withdrawals of deposits or non-renewal of deposits, delayed payment or default on loans, unexpected new loan demands from existing or new customers and so on Time Risk It happens when there is need to compensate for non-receipt of expected inflows of funds Call Risk It happens due to Crystallization of Contingent Liabilities like Letter of Credit, Bank Guarantee etc. The bank is forced to make immediate arrangement of funds if the claims on these liabilities are made. The maturity buckets given by RBI initially in its February 1999 guidelines were as follows: 1.1 to 14 days 2. 15 to 28 days 3. 29 days and upto 3 months 4. Over 3 months and upto 6 months 5. Over 6 months and upto 1 year 6. Over 1 year and upto 3 years 7. Over 3 years and upto 5 years 8. Over 5 years But, RBI realized that the first bucket (1-14 days) was not good enough to capture the liquidity requirements adequately and the bucket had to be more granular. So, RBI mandated splitting the bucket into 3 time buckets i.e Next Day, 2-7 days and 8-14 days. In every bucket, the bank has to calculate the cash inflows and cash outflows depending on the residual maturity of its assets and liabilities and then find out the mismatches in each bucket. If the Maturing Assets (M.A) Maturing Liabilities (M.L), there is a positive mismatch If the Maturing Assets (M.A) Maturing Liabilities (M.L), there is a negative mismatch In case of positive mismatch, there is excess liquidity in the bank for the concerned maturity bucket and this excess liquidity can be deployed in money market instruments, interbank lending in call money market, bill discounting, creating new assets, investment swaps etc. In case of a negative mismatch, there is shortage of liquidity in the bank for the concerned maturity bucket and this can be financed from interbank borrowings in call money market, bill rediscounting, Repo borrowings, liquidation of investments, deployment of foreign currency converted into Rupee and so on. This is the statement of Structural Liquidity which a bank must prepare daily and report to RBI atleast once every month, as on the 3rd Wednesday of every month. RBI has prescribed limits for the negative mismatches in the first 4 buckets. The net cumulative negative mismatches during the Next day, 2-7 days, 8-14 days and 15-28 days buckets should not exceed 5 % ,10%, 15 % and 20 % of the cumulative cash outflows in the respective first 4 buckets. However, a bank may keep additional limits at their own discretion in addition to these limits. A sample statement of Structural Liquidity that a bank prepares is as follows: INTEREST RATE RISK MANAGEMENT IN BANKS The deregulation of interest rates and the operational flexibility given to banks to price most of their assets and liabilities has led to the need of Interest Rate Risk Management. Interest Rate Risk arises when the change in the market interest rates adversely affect the banks financial condition by hitting its profits. The immediate impact of changes in interest rates is on banks earnings (i.e. reported profits) by changing its Net Interest Income (NII) and Net Interest Margin (NIM). A long-term impact of changing interest rates is on banks Market Value of Equity (MVE) or Net Worth because the economic value of banks assets, liabilities and off-balance sheet positions get affected due to fluctuations in market interest rates. The Interest Rate Risk can be viewed from 2 perspectives: Earnings Perspective The risk from the earnings perspective is measured by changes in the banks Net Interest Margin (NIM) and Net Interest Income (NII). There are many techniques for measuring the same such as Gap Analysis, Duration Gap Analysis, Simulation, Value at Risk (VaR) and so on. Traditional Gap Analysis The focus of the Traditional Gap Analysis is to measure the level of a banks exposure to interest rate risk in terms of sensitivity of its NII to interest rate movements. It involves bucketing of all Rate Sensitive Assets (RSA) and Rate Sensitive Liabilities (RSL) and off balance sheet items as per their residual maturity/re-pricing date in various time bands. It may also involve computing Earnings at Risk (EaR) i.e. loss of income under different interest rate scenarios over a time horizon of one year. In every time bucket given by RBI, the RSA and RSL are computed and the positive or negative Gap is found out. If RSARSL, there is a Positive Gap and in such a scenario, an increase in market interest rates will lead to increase in the banks NIM as there are more assets which are re-pricing in the concerned time bucket than the liabilities which are re-pricing. If RSARSL, there is a Negative Gap and in such a scenario, an increase in market interest rates will lead to decrease in the banks NIM as there are more liabilities which are re-pricing in the concerned time bucket than the assets which are re-pricing. Hence, if the bank feels that the interest rates are going to rise under the current scenario, it is favourable for the bank to maintain a positive Gap and if it feels that the interest rates are going to decline in the near future, it is favourable for the bank to maintain a negative Gap. Economic Value Perspective Duration Gap Analysis (DGA) The focus of the DGA is to measure the banks exposure to interest rate risk in terms of sensitivity of Market Value of its Equity (MVE) to interest rate fluctuations. The DGA involves bucketing of all RSA and RSL same as done in Traditional Gap analysis and computing the Modified Duration Gap (MDG). This can be used to evaluate the impact on the MVE of the bank under different interest rate scenarios. Modified Duration (MD) of an asset or liability measures the approximate percentage change in its value for a 1% change in the rate of interest. The larger the Modified Duration Gap, the more is the bank exposed to interest rate shocks. Interest Rate Sensitivity Time Buckets Earlier, the maximum bucket for sensitive items was over 5 years, but it has been revised now to Over 5 yrs, 5 yrs to 7 yrs, 7 yrs to 10 yrs, 10 yrs to 15 yrs and over 15 yrs as the banks have forayed greatly into long term assets like home loans, infrastructure loans and so on which have a maturity well in excess of 5 years. Sample Statement of Interest Rate Sensitivity Analysis ASSET LIABILITY MANAGEMENT AT STATE BANK OF INDIA (SBI) The Asset and Liability Management Committee of the bank (ALCO) is given the primary role of Liquidity Management and Interest Rate Risk Management. ALM department provides various data, reports and information to ALCO to enable them to monitor the same and provide necessary guidelines. The Global Market Department gets the various reports, data from Asset Liability Management Department on a daily basis and takes decisions regarding liquidity management and interest rates on various instruments in consultation with ALCO. ALCO can meet as and when required but at least once in a month. ALCO The Asset -Liability Management committee (ALCO) presently has the following members: Managing Director Chief Credit and Risk Officer Managing Director Group Executive (Associates Subsidiaries) Deputy Managing Director Group Executive (Global Markets) Deputy Managing Director Group Executive (Mid Corporate) Deputy Managing Director Group Executive (National Banking) Deputy Managing Director (Corporate Strategy and New Business) Deputy Managing Director Group Executive (Rural Business) Deputy Managing Director Chief Financial Officer Chairman Deputy Managing Director Group Executive(Corporate Banking) Deputy Managing Director Group Executive (International Banking) Chief General Manager (Financial Control) Member Secretary LIQUIDITY RISK MANAGEMENT AT SBI The bank measures the mismatches in cash inflow and cash outflow by calculating the Maturity Gap Analysis over several time buckets. While computing the gap, assets (inflow)/liabilities (outflow) are placed as per their remaining maturities. In the case of assets/liabilities without any contractual maturity (SB/CA/CC etc.,) the maturity patterns are based on behavioral study of these portfolios with the approval of ALCO. A large portion (presently taken as 40%) of retail term deposits due for maturity are assumed to be rolled over and accordingly put in longer time bucket of outflow. Similarly a small portion of our Non Fund-Based business (for LC 5% and for BG 1.5%) are assumed to devolve and placed in outflows across several buckets. For example, Current Account and Savings Account balances are bifurcated into core and volatile portions and volatile portion is placed in the short-term buckets while core portion is placed in longer term buckets of outflow. This g ap analysis has to be done on daily basis but reported to RBI on 1st and 3rd Wednesdays of every month. RBI has prescribed limits only for negative net cumulative mismatches in the first 4 buckets in short-term period (5% for 1 day, 10% in 2-7 days, 15% for 8-14 days, 20% in 15-28 days). ALCO has however prescribed the upper limit of 20% for all other time buckets. Structural Liquidity report is compiled as above on a daily basis and put up to top management {CGM (FC) and DMD CFO}. Important Liquidity Ratios Liquidity Ratios Percentage Liquid Assets to Total Assets Range Liquid Assets to Total Deposits Range Liquid Assets to Near Short-Term Liabilities 100% No regulatory definition of liquid Assets and benchmarks. Accordingly, liquid assets are defined internally and the benchmarks are set matching with these definitions keeping in view with the banks risk appetite The definition of liquidity ratios that are monitored and the bench marks are approved by ALCO. ALM Department monitors these ratios INTEREST RATE RISK MANAGEMENT AT SBI The Gap Analysis statements prepared daily by ALM department and sent to Global Markets Department. Also, list of all deposit and lending rates of all commercial banks is prepared daily and sent to Global Markets Department, who may take decisions on changes in interest rates. Details of Growth in Advances and Deposits prepared daily and sent to Global Markets Department, who may look at the market conditions, the need for the bank and tweak rates on things like bulk deposits almost every day. The major changes in interest rates are done in consultation with ALCO. CONTINGENCY FUNDING PLAN (CFP) RBI guidelines say that all banks must prepare a contingency plan to measure the ability to withstand any unexpected liquidity crisis. Trigger Events: ÂÂ  As per the ALM policy, trigger event is said to have occurred if:Â Bank becomes a Net Borrower (Repo / CBLO / Money Market) continuously for 30 days and During that period the unencumbered excess SLR securities fall below 2% of fortnightly average deposits of previous quarter continuously for a period of 10 days. Quantitative Warning Signals Deposits decline by more than 5% of aggregate domestic deposits without corresponding decline in loans and other assets during previous 3 months. Loan portfolio increase by 5% without any significant increase in total deposits in last 3 months. Cumulative negative gaps in the time bucket 29 days up to 90 days exceeds 35% of cumulative outflows in that time bucket. The performance of the Bank as reflected from quarterly results has not been satisfactory. Qualitative Warning Signals Depositors request for early withdrawal of their funds. Accelerated run off of large fund providers. Real or perceived negative publicity Downgrade or announcement of potential down grade of rating by rating agencies. A decline of asset quality. The overall economy is witnessing a tight liquidity position. The Contingency Funding Plan is reviewed every quarter. It is monitored by ALM Department and report submitted to ALCO every quarter. SBI RESULTS Q3FY 2011 The CASA ratio is quite healthy at 48%, which has primarily led to cost of deposits coming down to 5.20% NIM is above 3% which is a manageable figure Provision Coverage Ratio is still well below stipulated 75%, stands at 64% and SBI has asked for extention in period to comply with the same. To get this to 64%, there has been huge amount of provisions made. In the current quarter also, the profit would be hit due to provisions. Net Interest Income has grown substantially both as compared to Q3 FY10 and also compared to 9M FY10, which is a good sign. As can be seen, Loan Loss provision has increased by more than 200% which has hit the profitability greatly. Deposits growth has been driven by strong growth in CASA (27%). Still deposit growth is just 14% YOY, which is much less than Advances growth of 22%. This has been the problem faced by most banks as the people have shifted from bank deposits to mutual funds and equity due to negative rate of return offered by bank d eposits. This has led to concern as Credit-to-deposit ratio has increased across banks significantly. In some banks, it has crossed 100%, which has alarmed RBI and RBI has warned banks to see to it. The credit-to-deposit ratio for SBI is 77%, increased from 71% and has also entered into caution area (tolerable is 60-70%) The lack in deposit growth has meant tight liquidity condition for all banks in past few months. Also, there is straight asset liability mismatch as the deposit growth was mainly due to CASA and advances growth was led by long term infrastructure funding, as much as 21% of total corporate advances. NIM reached 3.40% from 2.56% a year earlier. CAR of the bank remained at a healthy level of 13.16%, well above the min requirement of 9%. DEPOSIT RATES IN SBI Tenors Existing w.e.f. 03.01.2011 Â Revised w.e.f. 14.02.2011 7 days to 14 days 4.00 7 days to 14 days 4.00 15 days to 45 days 5.00 15 days to 45 days 5.00 46 days to 90 days 5.50 46 days to 90 days 5.50 91 days to 180 days 6.00 91 days to 180 days 6.00 181 days to less than 1 year 7.75 181 days to less than 1 year 7.75 1 year to 554 days 8.25 1 year to 554 days 8.25 555 days 9.00 555 days 9.25 556 days to less than 2 years 8.25 556 days to less than 2 years 8.25 2 years to 999 days 8.75 2 years to 999 days 8.75 1000 days 9.00 1000 days 9.25 1001days to less than 3 years 8.75 1001days to less than 3 years 8.75 3 year to less than 5 years 8.25 3 year to less than 5 years 8.25 5 years to less than 8 years 8.50 5 years to less than 8 years 8.50 8 years and up to 10 years 8.75 8 years and up to 10 years 8.75 As we can see, SBI, like all other Indian banks has had to increase its deposit rates to attract fresh deposits to bring their deposit growths and credit growth closer in line and bring their Credit-to-Deposit ratio to a tolerable level. This increase in deposit rates will affect the NIM of the bank in the ongoing quarter, but this was a necessary step to address the liquidity problem and not having to rely on repo borrowings to fund their credit growth. The economy, as a whole, has faces a liquidity crunch due to huge outgo of funds from the banking system to the Government on account of 3G auction, Broadband wireless spectrum auction, disinvestment programme by Government and also the fact that the people have shifted away from bank deposits to more lucrative investments like Mutual funds and equities. This is because the bank deposits have been giving negative real rate of returns in the current high inflationary scenario. RATIOS COMPARISON Banks Base Rate CASA RoE CAR State Bank of India 8.25% 48% 18% 13.16% Central Bank of India 9.50% 37% 11% 12.23% HDFC Bank 8.20% 51% 11.58% 16.3% Bank of Baroda 9.00% 38% 13% 14.36% ICICI Bank 8.75% 44.2% 10.77% 19.98% As we can see, SBI and HDFC have the lowest Base Rates and they have been able to achieve this due to their high CASA ratios, as compared to other banks. The Base Rates of all banks have gone up in the past few months as the RBI has increased the Repo Rates (the rate at which banks borrow short term funds from RBI) due to inflationary pressures in the economy. The Repo rate as of today is 6.50%. The CAR of all banks is well in excess of the stipulated minimum level of 9%. CONCLUSION The Asset-Liability Management is one of the most crucial functions of a bank in the highly competitive and complex business environment today. Asset-Liability Management is a co-ordinated management of a banks balance sheet to allow for different interest rate, liquidity and optionality shocks. ALM involves quantification of various market risks and conscious decision making with regard to asset liability structure in order to maximize interest earnings within the frame work of perceived risks. The apex governing body for commercial banks in India, RBI has given certain guidelines for ALM and the banks have to follows these to prepare the Structural Liquidity Statements and Interest Rate Sensitivity Statements. The Indian economy, as a whole has been facing liquidity crunch in the banking system due to large outgo of funds to Government due to 3G and Broadband auctions and Disinvestment initiatives by Government. Also, the deposit growth has been very low as compared to credit gro wth in banks due to negative real rate of return offered by bank deposits in current high inflationary scenario. This has meant negative liquidity mismatch for the banks, who have had to resort to short term Repo borrowings to fund their credit growth, leading to very high Credit-to-Deposit Ratios, which is a serious cause of concern as highlighted by RBI in its Monetary Policy Review. This has led to increase in deposit rates by most banks to attract fresh deposits from public. State Bank of India is the largest bank in India, having a very elaborate and complex ALM process. The Contingency Funding Plan (CFP) is also quite comprehensive and the Quarter 3 results showed that the ALM at SBI has been quite successful in keeping its NIM above 3%, CASA at more than 45% and CAR in excess of 13%. The only cause of concern has been the provisions made on NPAs, which have hit the banks profits a little bit. And, still the Provision Coverage Ratio is below the stipulated limit of 70%, whi ch means that huge provisions will have to made in the ongoing quarter as well, leading to lower profitability for the bank. SBI has also increased its deposit rates in the past 2 months to attract fresh deposits, which has been the case with all other banks. SBI hopes to bring its credit growth and deposit growth closer to each other in the ongoing and coming quarters to make its Asset-Liability position better and reduce its Credit-to-Deposit ratio, which is slightly higher than a tolerable level at present. Hence, Asset-Liability Management comes with its various challenges and complexities, but a bank has to give a lot of importance to this task, as it has a direct impact on a banks profitability and sustainability.