ALM and Fund Management

1
ALM and Fund Management

• Jyoti Kumar Pandey
• Deputy General Manager
• Member of Faculty
• College of Agricultural Banking, Pune

2
What is Banking

• Section 5(b) defines banking Accepting for the
  purpose of lending or investment of deposits or
  money repayable on demand or otherwise and
  withdrawable by cheque, draft, order or otherwise

Risk taking is an inherent function of banking -
Allan Greenspan
3
Banks get affected by

• Actions of Central Banks
• Actions of the Government
• Domestic and International Disturbances
• Inflation

4
Deregulation

• Banks are now operating in a fairly deregulated
  environment and are required to determine on
  their own, interest rates on deposits and
  advances
• Intense competition for business involving both
  the assets and liabilities together with
  increasing volatility in the interest rates has
  brought pressure on the management of banks to
  maintain a good balance among spreads

5
Risks Faced by Banks

• Credit Risk
• Market Risk
• Liquidity Risk
• Interest Rate Risk
• Operational Risk

6
Effects of Risk Factors

• Loss of Market Value
• Loss of Reserves
• Loss of stakeholders confidence

7
ALM

• The ALM guidelines issued by RBI has been
  formulated to serve as a benchmark for banks
  which lack a formal ALM system
• Those who already have their existing system may
  fine tune their information and reporting system

8
Purpose of ALM

• Capture the maturity structure of the cash flows
  (inflows and outflows) in the Statement of
  Structural Liquidity
• Tolerance levels for various maturities may be
  fixed by the bank keeping in view banks ALM
  profile, extent of stable deposit base, nature of
  cash flows etc.

9
ALM

• ALM is about managing market risk and liquidity
  risk together
• Capital market exposure of banks is small
• Exchange risk is highly specialized
• Hence ALM is an integrated risk management
  approach for managing liquidity risk, interest
  rate risk

10
The problem of mismatch

• Mismatches in maturity
• Mismatches in interest rate
• How does bank makes the spread?
• Borrow short and lend long and keep the spread
• Maturity mismatch is the basis of profitability
• Risk management does not eliminate mismatch
  merely manages them

11
The problem of mismatch

• Interest Rate Risk ? Affects profitability
• Liquidity Risk ? May lead to liquidation
• General Strategy
• Eliminate Liquidity Risk (not the mismatch)
• Manage Interest Rate Risk
• Consciously create gaps

12
Asset Liability Transformation

• Banks are exposed to credit and market risks in
  view of the asset-liability transformation
• With liberalisation, banks operations have
  become complex and large , requiring strategic
  management

13
ALM Pillars

• ALM Information Systems
• ALM Organisation
• ALM Process

Applicable to Scheduled UCBs and Tier II UCBs For
Tier II UCBs effective date is December 2008
14
ALM Pillars (Contd.)

• ALM Information systems
• MIS
• Information availability
• Accuracy
• Adequacy
• Expediency

15
ALM Pillars (Contd.)

• ALM Organisation
• Structure and responsibilities
• Level of top management involvement

16
ALM Pillars (Contd.)

• ALM Process
• Risk Parameters
• Risk Identification
• Risk Measurement
• Risk Management
• Risk Policies and Procedures, prudential limits
  and auditing, reporting and review

17
ALM Information Systems

• ALM framework built on sound methodology with
  necessary information system back-up
• ALM to be supported by management philosophy and
  clearly states risk policies and procedures /
  prudential limits
• Banks may utlilise Gap Analysis or Simulation
• Important to have availability of timely,
  adequate and accurate information

18
ALM Information Systems (Contd.)

• ALM Data could be developed by following
  approach, in case UCBs do not have requisite
  information
• Analyse behaviour of asset and liability products
  in sample branches that account for significant
  business (60-70 per cent)
• Based on this make rational assumption for the
  other branches

UCBs have limited area of operations and hence it
would be easier for them to make such assumptions
and better access to data
19
ALM Organisation

• Board should have overall responsibility for
  management of risk
• Board should decide risk management policy and
  procedure, set prudential limits, auditing,
  reporting and review mechanism in respect of
  liquidity, interest rate and forex risk
• ALCO
• Consisiting of banks senior management including
  CEO
• Responsible for adherence to the polices and
  limits set by Board
• Responsible for deciding business strategies (on
  asset liability side) in line with banks
  business and risk objectives
• ALM Support Group
• Consisting of operating staff
• Responsible for analysing, monitoring and
  reporting risk profiles to ALCO
• Prepare forecasts showing effects of various
  possible changes in market conditions affecting
  balance sheet and suggesting action to adhere to
  banks internal limits

20
ALM Organisation (Contd.)

• ALCO decision making unit responsible for
• Balance Sheet planning from risk-return
  perspective which includes management of
  liquidity, interest rate and forex risks
• Pricing of deposits and advances, desired
  maturity profile etc.
• Monitoring the risk levels of the bank
• Review of the results and progress of
  implementation of decisions made in previous
  meeting
• Future business strategies based on banks
  current view on interest rates
• To decide on source and mix of liabilities or
  sale of assets
• To develop future direction of interest rate
  movements
• To decide on funding mix between fixed and
  floating rate funds, wholesale vs. retails
  deposits, short term vs. long term deposits etc.

21
ALM Organisation (Contd.)

• ALCO size would be dependent on the size of the
  UCB
• May comprise of
• CEO or Secretary
• Chief of Investment / Treasury including those of
  forex, credit, planning etc.
• Head of IT if a separate division exists
• UCBs may at their discretion may have
  Sub-committees and Support Groups

22
ALM Process

• Scope is
• Liquidity Risk Management
• Interest Rate Risk Management
• Trading (Price) risk Management
• Funding and Capital Management
• Profit Planning and business Projections

UCBs, generally, are not exposed to forex risk
23
ALM

• Liquidity Risk

• Interest Rate Risk

24
Liquidity Risk

• Arising due to
• Over extension of credit
• High level of NPAs
• Poor asset quality
• Mismanagement
• Hot Money
• Non recognition of embedded option risk
• Reliance on few wholesale depositors
• Large undrawn loan commitments
• Lack of appropriate liquidity policy and
  contingent plan

25
Liquidity vs. Earnings

• Bank must be in a position to-
• Balance their need for liquidity with their need
  for earnings
• More liquid assets tend to provide lower return
  than do less liquid assets

26
Assessing Liquidity Position

• Assessing a banks liquidity position can be
  challenging
• An adequate position for one bank may not be
  sufficient for another
• A position considered adequate for a bank in one
  time period may not be so in another
• BANK SPECIFIC DYNAMIC

27
Liquidity risk-Manifestation

• Funding risk
• Need to replace net outflows due to unanticipated
  withdrawal/non-renewal of deposits
• Time Risk
• Need to compensate for non-receipt of expected
  inflows of funds-performing assets turning into
  non-performing assets

28
Liquidity Risk (Contd.)

• Regulatory Requirements
• CRR / SLR
• Call Money Borrowings prescriptions / limits
• ALM Guidelines
• Host country prescriptions
• Overseas Offices of Indian Banks

29
Factors Reducing Liquidity Risk

• Availability of Refinance
• LAF Facility
• Open Market Operations
• CBLO

30
Liquidity Risk - Symptoms

• Offering higher rate of interest on deposits
• Delayed payment of matured proceeds
• Delayed disbursement to borrowers against
  committed lines of credit
• Deteriorating asset quality
• Large contingent liabilities
• Net deposit drain

31
Liquidity Risk - Measurement

• Two methods are employed
• Stock approach - Employing ratios
• Flow approach - Time bucket analysis

32
Liquidity Risk - Measurement

• Liquidity Ratios
• Volatile Liability Dependence Ratio
• Volatile Liabilities minus Temporary Investments
  to Earning Assets net of Temporary Investments
• Shows the extent to which banks reliance on
  volatile funds to support Long Term assets
• where volatile liabilities represent wholesale
  deposits which are market sensitive and temporary
  investments are those maturing within one year
  and those investments which are held in the
  trading book and are readily sold in the market
• Growth in Core Deposits to growth in assets
• Higher the ratio the better

33
Liquidity Risk Measurement (Contd.)

• Purchased Funds to Total Assets
• where purchased funds include the entire
  inter-bank and other money market borrowings,
  including Certificate of Deposits and
  institutional deposits
• Loan Losses to Net Loans
• Loans to core deposits

34
Liquidity Risk Measurement (Contd.)

• Does not lead to proper assessment of liquidity
  gaps due to
• Illiquidity of liquid assets
• Their ready marketability
• Difficulty to convert easily into liquid cash
  with least loss of value from the previously
  quoted market rates

35
Liquid Assets to Total Assets

• Liquid Assets to Total Assets
• Show the percentage of liquid assets in the asset
  structure of the bank - 18-20
• Liquid assets generally are cash balances with
  RBI balances with other banks investments
  available for sale money market instruments

36
Liquid Assets to Total Deposits

• Liquid Assets to Total Deposits
• This ratio indicates extent of liquidity
  maintained by a bank for meeting the demand made
  by the depositors-Sometimes taken as a measure of
  bank liquidity-20-22

37
Loans to Deposits

• Loans to Deposits
• Loans to deposits ratio indicates the degree to
  which the bank has already used up its available
  resources to accommodate the credit needs of the
  customers
• A high loan deposit ratio indicates that a bank
  will have comparatively low liquidity

38
Loans to Assets

• Loans to Assets
• This ratio indicates the percentage of illiquid
  assets to total assets
• A rise in this ratio would indicate lower
  liquidity

39
Loans to Core Deposits

• Loans to Core Deposits
• Those deposits which are not subject to any large
  volatility
• Average level of previous years deposit is
  generally taken as core deposits
• This ratio helps in assessing level of deployment
  of core portion of deposits

40
Loans to Investments

• Loans to Investments
• While loans provide higher returns compared to
  investments, these suffer from credit risk and
  are more illiquid than investments
• A proper mix of loans and investments keeping in
  view liquidity and yield considerations need to
  be fixed

41
Cash Flow Approach

• Preparing a structural liquidity by taking into
  account balance sheet on particular date and
  place in maturity ladder according to time
  buckets
• Identify the liquidity needs - to evolve methods
  to meet it
• Negative gaps in individual time buckets indicate
  the need. The need could be controlled by
• prudential limits
• as also by regulating the basis of business
  structure/financial flexibility of banks
• Regulatory Limit of 20 on outflows in first two
  time buckets

42
RBI Guidelines on Liquidity Risk

• Methodology prescribed in ALM System- Structural
  Liquidity Statement Dynamic Liquidity Ladder
  are simple
• Need to make assumptions and trend analysis-
  Behavioural maturity analysis
• Variance Analysis at least once in six months and
  assumptions fine-tuned
• Track the impact of exercise of options
  potential liquidity needs
• Cap on inter-bank borrowings Call money

43
Structural Liquidity Statement Sch. UCBs

• SSL Layout

Circular Sept. 17, 2008 for Scheduled UCBs More
granular approach adopted by splitting first
bucket of 1 14 days in SSL into Next Day, 2-7
days and 8 14 days Net cumulative negative
mismatches during the Next Day, 2 7 days, 8
14 days and 15 28 days bucket should not exceed
5, 10, 15 and 20 of the cumulative cash
outflows in the respective buckets Banks may
undertake dynamic liquidity management and should
prepare the SSL on daily basis to Top Management
/ ALCO SSL may be reported to RBI at fortnightly
intervals within 10 days of the reporting
Friday Revised format would be applicable from
January 01, 2009 UCBs in Tier II are also
covered Scheduled UCBs to report structural
liquidity position and interest rate sensitivity
to RBI as part of OSS data
44
Structural Liquidity Statement Sch. UCBs
(Contd.)
45
Structural Liquidity Statement Sch. UCBs
(Contd.)
46
Structural Liquidity Statement Sch. UCBs
(Contd.)
47
Structural Liquidity Statement Sch. UCBs
(Contd.)

• Liability on account of event cash flows CRR /
  SLR shortfall, wage settlement and any other
  contingency under respective maturity bands
• All overdue liabilities in Day 1, 2 7 days and
  8 14 days bucket based on behavioral estimates
• Interest and installments from advances and
  investments which are due for less than one month
  1-6 months time band
• Interest and installments from advances and
  investments which are over due for less than one
  month may be placed in Day 1, 2-7 days and 8 14
  days based on behavioral pattern. Further,
  interest and installments due (before
  classification as NPAs may be placed in 29 days
  3 months bucket if the earlier receivables remain
  uncollected

48
Liquidity Risk Management for Tier 1 UCBs

• Basic guidelines for liquidity management issued
  on September 17, 2008
• Banks advised to prepare
• Statement of Structural Liquidity and
• Statement of Short Term Dynamic Liquidity
• To be prepared as on the last reporting Friday
  of March / June / September / December and submit
  to the Board within one month from the last
  reporting Friday
• First such submission to be made to the Board as
  on last reporting Friday of December 2008

49
Liquidity Risk Management for Tier 1 UCBs (contd.)

• Maturity profile of SSL into 8 buckets
• 1-14 days
• 15-28 days
• 29 and up to 3 months
• Over 3months and up to 6 months
• Over 6 months and up to 1 year
• Over 1 year and up to 3 years
• Over 3 years and up to 5 years
• Over 5 years
• Mismatches (negative gaps) during 1-14 and 15-28
  days time bands in normal course should not
  exceed 20 of the cash flows in each time band

50
Liquidity Risk Management for Tier 1 UCBs (contd.)

• Short Term Dynamic Liquidity Statement
• 1-14 days
• 15-28 days
• 29-90 days
• STDL required for securities in the trading book
• SLR investments / securities are generally not
  very liquid and lack depth and are therefore
  shown in the residual maturity bands
  corresponding to residual maturity

51
Liquidity Risk Management for Tier 1 UCBs (contd.)

• Holding period not to exceed 90 days
• Cut loss limit is prescribed
• Defeasance periods are prescribed Time taken to
  liquidate the position on the basis of liquidity
  in the secondary market are prescribed
• Marking to market on a weekly basis

52
Trading Book

• Maintained distinctly from those required for
  complying with Statutory Reserve Requirements
• Subject to preconditions
• Composition and volume clearly defined
• Maximum maturity / Duration of the portfolio
  restricted
• Holding period not exceeding 90 days
• Cut Loss prescribed
• Marked to market on a weekly basis

53
Maturity Profile Liquidity for Tier 1 UCBs
54
Maturity Profile Liquidity for Tier 1 UCBs
(contd.)
55
Maturity Profile Liquidity for Tier 1 UCBs
(contd.)
56
ALM for Tier II UCBs

• Similar to what prescribed to Scheduled UCBs
• Initially at least 60 of assets and liabilities
  to be covered and remaining 40 on assessment
  basis only
• 100 coverage by April 01, 2010
• Statements required to be prepared
• Statement of Structural Liquidity
• Statement of Interest Rate Sensitivity
• Short-Term Dynamic Liquidity Statement

57
ALM for Tier II UCBs SSL

• To be prepared, to start with, as on last
  reporting Friday of March / June / September /
  December
• To be put up to the ALCO / Top Management within
  a month from the close of the last reporting
  Friday
• Reporting on a fortnightly basis from December
  2008 (intended)
• Maturity profile of SSL into 8 buckets
• 1-14 days
• 15-28 days
• 29 and up to 3 months
• Over 3months and up to 6 months
• Over 6 months and up to 1 year
• Over 1 year and up to 3 years
• Over 3 years and up to 5 years
• Over 5 years

58
ALM for Tier II UCBs SSL (contd.)

• Mismatches in cash flows to be kept at minimum
• Initially for 1-14 and 15-28 days it may not
  exceed 20 normally
• In case banks wishes to operate on a higher
  limit, it could be done with approval of the
  Board / Management
• Objective of RBI is to enforce tolerance level
  strictly with effect from April 01, 2010

59
ALM for Tier II UCBs SIRS

• Only rupee assets, liabilities and off-balance
  sheet positions to be reported
• Statement to be prepared as on last Friday of
  March / June / September / December
• To be submitted to ALCO / Top Management within
  one month of reporting Friday
• To be placed before the Board in its next meeting
• Banks expected to move over to monthly reporting
  system from April 01, 2010

60
ALM for Tier II UCBs SIRS (contd.)

• Maturity profile of SIRS into 7 time bands
• Up to 3 months
• Over 3months and up to 6 months
• Over 6 months and up to 1 year
• Over 1 year and up to 3 years
• Over 3 years and up to 5 years
• Over 5 years
• Non-sensitive
• Gap is the difference between Rate Sensitive
  Assets (RSA) and Rate Sensitive Liabilities (RSL)
• If RSA gt RSL ve Gap Bank benefits if
  interest rate goes up
• If RSA lt RSL or RSL gt RSA -ve Gap Bank
  benefits if interest rate goes down

61
ALM for Tier II UCBs SIRS (contd.)

• Banks to set prudential limits on individual gaps
  with the approval of the Board
• The prudential limits should have a bearing on
  the Total Assets, Earning Assets or Equity
• Banks need to work out Earnings at Risk (EaR)
  i.e. 20 30 of the last years NII or Net
  Interest Margin based on their views of
  interest rate movements
• After sufficient experience is gained by the UCB
  in ALM, RBI may consider introduce capital
  adequacy for market risk

62
ALM for Tier II UCBs STDS

• To be prepared as on each reporting Friday
• To be put up to the ALCO / Top Management within
  2-3 days from the close of the reporting Friday

63
ALM for Tier II UCBs Other Issues

• SSL and SIRS could be reported through OSS
• Communication to be issued
• All the three ALM Statements may be put up to the
  ALCO as on last Friday of December 2008

64
Some points

• Break the beyond 5 year bucket into financial and
  non-financial
• The sum of all the gaps in the structural
  liquidity may or may not be zero
• The cumulative gaps also called forward payment
  structure
• Why is the forward payment structure significant?
• Stress testing

65
Cumulative Gaps

• Forward Payment Structure indicates future
  liquidity position
• Long term strategic approach needed to correct an
  increasingly negative FPS

66
Dynamic Liquidity Gap Analysis

• Tracking cash flow on a short term time horizon-
  changes on account of fresh business are
  interpolated in the projections
• RBI has asked banks to monitor short term
  liquidity on a dynamic basis over time horizon
  spanning from 1-90 days

67
Short-Term Dynamic Liquidity Statement

• Main focus on short term mismatches
• 1-14days
• 15-28 days
• 29-90 days

68
Dynamic Liquidity Analysis(Amount Rs. Crore)
69
Interest Rate Risk

• Changes in yield curve of G-Secs
• Changes in administered rate of interest
• Changes in forward exchange rates
• Changes in prices of other assets and inflation
  rates

70
Reasons for Interest Rate Risk

• On account of asset transformation
• Many deposits are used for one big loan
• Periodical review of assets and liabilities
• Due to mismatches between maturity / repricing
  dates as well as maturity amounts between assets
  and liabilities
• Depositors and borrowers may pre-close their
  accounts

71
RSA and RSL

• Rate Sensitive Assets (RSA) Assets whose value
  is dependent on current interest rate
• Risk Sensitive Liabilities (RSL) Liabilities
  whose value is dependent on current interest rate

72
Gap / Mismatch Risk

• Arises on account of holding RSA and RSL with
  different principal amounts, maturity / repricing
  rates
• Even though maturity dates are same, if there is
  a mismatch between amount of assets and
  liabilities it causes interest rate risk and
  affects NIM

73
Interest Rate Risk

• Assessed by Gap Report Gaps between RSA and RSL
• Asset / Liabilities are rate sensitive if
• Within the time interval under consideration
  there is a Cash Flow
• Repayment of term loans
• Interest rate resets / reprices
• Change in interest rate in CC account, Term Loans
  before maturity
• RBI changes interest rates
• Interest on Savings Bank Deposits, CRR balance
  etc.

74
Interest Rate Risk (contd.)

• Assessed by Gap Report Gaps between RSA and RSL
• Gaps may be identified in the following time
  bands
• 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
• Non-sensitive

75
Interest Rate Risk (contd.)

• Immediate impact of changes is on banks profit
  by change in its spread NII
• NII gives the earning perspective
• Long term impact is change in its MVE or Net
  Worth
• As marked to market value of banks asset
  liabilities, off-balance sheet positions get
  affected
• Gives the economic value perspective

76
Interest Rate Risk (contd.)

• Each bank to set its prudential limits on
  individual gaps with approval of Board
• Prudential limits set with respect to bearing on
  Total Assets, Earning Assets or Equity
• Banks may work out their Earnings at Risk
  20-30 of last years NII or NIM

77
Interest Rate Sensitivity (Contd.)
78
Interest Rate Sensitivity (Contd.)
79
Interest Rate Sensitivity (Contd.)
80
Gist

• Scheduled UCBS and Tier II UCBs
• Have 3 pillars I n place
• ALM Information Systems
• ALM Organisation
• ALM Process
• Prepare 3 statements
• Statement of Structural Liquidity (quarterly)
• Short Term Dynamic Liquidity Statement
  (fortnightly)
• Statement of Interest Rate Sensitivity
  (quarterly)
• Review of Statements by ALCO / Top Management
• To report from last reporting Friday of December
  2008
• SIRS to be moved to monthly reporting by April
  01, 2010
• SSL to be fortnightly basis from December 2008

81
Gist (contd.)

• Scheduled UCBs already reporting SSL and SIRS
  through OSS
• For Tier II UCBs separate communication to follow

82
Gist (contd.)

• Tier I UCBs
• Prepare 2 Statements
• Statement of Structural Liquidity (quarterly)
• Statement of Short Term Dynamic Liquidity
  (quarterly)
• To be put up to the Board as on last Friday of
  December 2008
• For reporting through OSS separate communication
  to follow

83
Thank You