ASSET LIABILITY MANAGEMENT IN BANKS (ALM)

What is ALM ?

In banking, asset and liability management is the practice of managing risks that arise due to
mismatches between the assets and liabilities (debts and assets) of the bank. This can also be seen in
insurance.

Banks face several risks such as the liquidity risk, interest rate risk, credit risk and operational risk. Asset
Liability management (ALM) is astrategic management tool to manage interest rate risk and liquidity risk
faced by banks, other financial services companies andcorporations.

Banks manage the risks of Asset liability mismatch by matching the assets and liabilities according to the
maturity pattern or the matching the duration, by hedging and by securitization. Much of the techniques
for hedging stem from the delta hedging concepts introduced in theBlack-Scholes model and in the work
of Robert C. Merton and Robert A. Jarrow. The early origins of asset and liability management date to the
high interest rate periods of 1975-6 and the late 1970s and early 1980s in the United States. Van
Deventer, Imai and Mesler (2004), chapter 2, outline this history in detail.

Modern risk management now takes place from an integrated approach to enterprise risk
management that reflects the fact that interest rate risk, credit risk, market risk, and liquidity risk are all
interrelated. The Jarrow-Turnbull model is an example of a risk management methodology that integrates
default and random interest rates. The earliest work in this regard was done by Robert C. Merton.
Increasing integrated risk management is done on a full mark to market basis rather than the accounting
basis that was at the heart of the first interest rate sensivity gap and duration calculations.

Asset and Liability Management (ALM) There are different organizational and governance models that guide the

management of bank asset and liability activities. The models reflect fundamentally different risk philosophies that

tend to evolve with the growing sophistication and depth of financial markets together with the position and

activities undertaken by a bank in the market. The terms ‘ALM unit’ and ‘treasury unit’, can be confusing as they are

often used by organizations who assign different responsibilities to them - this will be explained below.

Key aspects that influence a banks approach

1. The evolution of models is driven by differing philosophies about the role of the treasury or the ALM unit and banks

in markets at different stages of development often regard the treasury unit differently.

2. In emerging markets the treasury function is usually simplistic and a support function mainly focused on liquidity

management and basic foreign exchange activity. In these banks, it is not uncommon to have a prohibition on

involvement in more sophisticated capital markets transactions such as derivatives due to lack of knowledge and

suspicion about the instruments. Such markets can suffer from poorly developed capital markets that provide little
capacity to offset the risks assumed from the customer franchise. The result is often that these banks are slow to

evolve and run risks, without knowing it, which can threaten their very survival.

3. In developing markets the treasury function usually begins to take on more structure, more activities and a broader

mandate. At the simpler end of the spectrum it can assume full balance sheet management responsibility, involving

itself in more complex analytics and hedging activities. At the more complex end it can assume trading and market

making responsibilities for a range of capital market products that are used in hedging but also are provided to

customers. This can often be referred to as an ‘integrated treasury function’, with profit making as well as hedge

management the central themes.

4. In developed markets the model usually evolves by separating out the trading and market making functions into a

more customer centric unit such as a capital markets or institutional banking division, with a subsequent refocusing

of the core ALM functions on more detailed analysis, and management of the banks’ assets, liabilities and capital

base. Treasury becomes more of a service centre in these banks, providing assistance and support with pricing and

analytics to customer facing divisions. The ALM or balance sheet can often be managed aggressively through the

use of derivative contracts. Funds transfer pricing mechanisms are used extensively to create economic

transparency and to immunize business units to risk.

5. In all models the ALM function reports to either the CEO / CFO with the CFO generally having the day to day

responsibility for the ALM core functions. Under all models it is important to establish a clear understanding of

activities and risk thresholds in the Treasury function and ensure the risk framework is aligned to the operating

structure and market realities. Establishing a governance structure within which the board of the bank is fully informed

and cognisant of the risks being run is a critical and mandatory component.

6. It is in the more developed markets that the Chief Risk Officer function has developed and come to represent the

single independent point of oversight both internally and externally.

Focus on some key ALM activities

36. Successful ALM units create a properly aligned risk and return management process. The right mix between skills

and risk appetite must be identified, expected outcomes of activities known and appropriate metrics established. The

approach adopted needs to be aligned to the realities of the market the bank is operating within and to its desired risk

appetite.

Mismatch Management and Performance Measurement

1. A bank needs to decide whether it wants to take a relatively neutral approach to ALM risks or is prepared to take a

more aggressive approach and target higher long term earnings and an increase in economic value. Irrespective of

the choice made, a bank needs to realise that the right level of skills and resources need to be committed to support

the function. Failure to do this can result in a poorly managed operation characterised by volatility in; core

earnings/margin; economic value, and; unpredictable economic results.

2. The mismatch position of the balance sheet represents the interest rate and liquidity risk profile inherent.

Assuming a single portfolio without hedges, a large and well diversified bank, with transactions weighted broadly

across all market segments, will find that its balance sheet will naturally take on countercyclical characteristics as

the business environment consolidates through the economic cycle. This makes sense as the bank is effectively

providing customers with solutions they are demanding as they operate in the external environment. The market

itself will also provide limitations and one of the areas where this can manifest strongly is on the liability side of the

balance sheet. Various techniques are used to examine the mismatch in a bank’s balance sheet and it can be a

difficult process if not supported with adequate systems. Depending on systems and analytical support the ALM

process will undertake a number of analysis designed to identify; static and dynamic mismatch; sensitivity of net

interest income; and, market value under multiple scenarios -including under high stress.

3. The majority of banks set net interest income (NII) limits as a main measure of performance with the more

advanced banks also using market or economic value as a secondary measure. NII has become the industry

benchmark simulation tool because; it is relatively easy to understand and implement; it’s a single period measure

that does not require many assumptions, and; it is easy for investors to relate to because it is directly linked to

reported financial results. On the negative side, it is limited as it does not provide a full view of the risks run by a

bank or reflect fully the economic impact of interest rate movements. Market value or economic value simulations on

the other hand, offer a more complete assessment of the risk being run but require significantly more detailed

analysis which is out of reach of many banks at this point. The process requires multiple assumptions that are

difficult to form in some cases and is less intuitive and more difficult to understand. Notwithstanding the difficulties of

the latter, both metrics are important in the measurement and management of embedded risk in banks. In less

developed ALM units, the time it takes to collect and analyse information can render much of it useless for active

management as by the time it is available markets have moved making hedging ineffective.

4. Access to timely and accurate data is critical in support of any form of ALM activity.

Funds Transfer Pricing (FTP)

1. The funds transfer pricing system has become a fundamental ALM tool in a bank. It creates the ability to immunize

business units from risk and provides the basis for economic and product transparency.

2. The process of FTP is designed to identify interest margins and remove interest rate and funding or liquidity risk.

Looking at it from the business unit perspective, it effectively locks in the margin on loans and deposits by assigning

a transfer rate that reflects the repricing and cash flow profile of each balance sheet item – it is applied to both

assets and liabilities. From the ALM unit’s perspective, it isolates business performance into discrete portfolios that

can be assigned individualised metrics and facilitates the centralisation and management of interest rate

mismatches. A by-product is that it effectively allocates responsibilities between the organizational business units

and the treasury department.

3. In more developed banks, the FTP mechanism can also be used as a tool to assist with management of the

balance sheet structure with FTP rates adjusted to either encourage or discourage product and customer flows. The

associated analytical process leads to greater understanding of a bank’s competitive advantage, assisting with asset

allocation and protection of the franchise. Similarly, in smaller and/or less developed banks it is of equal value as

both a management and strategy tool.

4. The methods used by banks are generally consistent - FTP rates are structured to include both interest rate and

funding liquidity risks with the derived transfer yield curve constructed to include appropriate premiums. Such

premiums should capture all elements associated with the banks funding cost. These should include the cost of

items such as; holding liquidity reserves; optionality costs, where pre-payment rights exist; term funding program

costs; and, items such as basis risk.

Liquidity Management

1. The main liquidity concern of the ALM unit is the funding liquidity risk embedded in the balance sheet. The funding

of long term mortgages and other securitised assets with short term liabilities (the maturity transformation process),

has moved to centre stage with the contagion effect of the sub-prime debacle. Both industry and regulators failed to

recognise the importance of funding and liquidity as contributors to the crisis and the dependence on short term

funding created intrinsic flaws in the business model. Banks must assess the buoyancy of funding and liquidity

sources through the ALM process.

2. Banks are in the business of maturity transformation to meet their customers’ requirements and these result in

liquidity, interest rate and currency mismatches which need to be managed. ALM units have traditionally analysed

and ‘managed’ liquidity within pre set limits; however it is only the recent crises that have brought its true importance

into focus. Failure to manage effectively can have dire results but the events of recent times have demonstrated that

liquidity impacts can be cataclysmic to a bank.

3. Like all areas of risk management, it is necessary to put a workable framework in place to manage liquidity risk. It

needs to look at two aspects: 1) Managing liquidity under the business as usual scenario, and 2) Managing liquidity

under stress conditions. It also needs to include a number of liquidity measurement tools and establish limits against

them.

ALM is a comprehensive and dynamic framework for measuring, monitoring and managing the
market risk of a bank. It is the management of structure of balance sheet (liabilities and assets) in
such a way that the net earning from interest is maximised within the overall risk-preference
(present and future) of the institutions. The ALM functions extend to liquidly risk management,
management of market risk, trading risk management, funding and capital planning and profit
planning and growth projection.

Benefits of ALM - It is a tool that enables bank managements to take business decisions in a
more informed framework with an eye on the risks that bank is exposed to. It is an integrated
approach to financial management, requiring simultaneous decisions about the types of amounts
of financial assets and liabilities - both mix and volume - with the complexities of the financial
 markets in which the institution operates

The concept of ALM is of recent origin in India. It has been introduced in Indian Banking
industry w.e.f. 1st April, 1999. ALM is concerned with risk management and provides a
comprehensive and dynamic framework for measuring, monitoring and managing liquidity,
interest rate, foreign exchange and equity and commodity price risks of a bank that needs to be
closely integrated with the banks’ business strategy.

Therefore, ALM is considered as an important tool for monitoring, measuring and managing the
market risk of a bank. With the deregulation of interest regime in India, the Banking industry
has been exposed to the market risks. To manage such risks, ALM is used so that the
management is able to assess the risks and cover some of these by taking appropriate decisions.

The assets and liabilities of the bank’s balance sheet are nothing but future cash inflows or
outflows. With a view to measure the liquidity and interest rate risk, banks use of maturity ladder
and then calculate cumulative surplus or deficit of funds in different time slots on the basis of
statutory reserve cycle, which are termed as time buckets.

As a measure of liquidity management, banks are required to monitor their cumulative

mismatches across all time buckets in their Statement of Structural Liquidity by
establishing internal prudential limits with the approval of the Board / Management
Committee.

The ALM process rests on three pillars:

i. ALM Information Systems

o Management Information Systems
o Information availability, accuracy, adequacy and expediency
ii. ALM Organisation
o Structure and responsibilities
o Level of top management involvement
iii. ALM Process
o Risk parameters
o Risk identification
o Risk measurement
o Risk management
o Risk policies and tolerance levels.

As per RBI guidelines, commercial banks are to distribute the outflows/inflows in

different residual maturity period known as time buckets. The Assets and Liabilities
were earlier divided into 8 maturity buckets (1-14 days; 15-28 days; 29-90 days; 91-180
days; 181-365 days, 1-3 years and 3-5 years and above 5 years), based on the remaining
period to their maturity (also called residual maturity). All the liability figures are
outflows while the asset figures are inflows. In September, 2007, having regard to the
international practices, the level of sophistication of banks in India, the need for a sharper
assessment of the efficacy of liquidity management and with a view to providing a stimulus for
development of the term-money market, RBI revised these guidelines and it was provided that
 • (a) the banks may adopt a more granular approach to measurement of liquidity risk by splitting the
first time bucket (1-14 days at present) in the Statement of Structural Liquidity into three time
buckets viz., next day , 2-7 days and 8-14 days. Thus, now we have 10 time buckets.

After such an exercise, each bucket of assets is matched with the corresponding bucket of
the liabililty. When in a particular maturity bucket, the amount of maturing liabilities or assets
does not match, such position is called a mismatch position, which creates liquidity surplus or
liquidity crunch position and depending upon the interest rate movement, such situation may
turnout to be risky for the bank. Banks are required to monitor such mismatches and take
appropriate steps so that bank is not exposed to risks due to the interest rate movements
during that period.

• (b) 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 time buckets in order to recognise the cumulative impact on liquidity.

The Board’s of the Banks have been entrusted with the overall responsibility for the
management of risks and is required to decide the risk management policy and set limits
for liquidity, interest rate, foreign exchange and equity price risks.

Asset-Liability Committee (ALCO) is the top most committee to oversee the

implementation of ALM system and it is to be headed by CMD or ED. ALCO considers
product pricing for both deposits and advances, the desired maturity profile of the incremental
assets and liabilities in addition to monitoring the risk levels of the bank. It will have to articulate
current interest rates view of the bank and base its decisions for future business strategy on this
view.

Rate Sensitive Assets & Liabilities : An asset or liability is termed as rate sensitive
when

(a) Within the time interval under consideration, there is a cash flow,

(b) The interest rate resets/reprices contractually during the interval,

(c) RBI changes interest rates where rates are administered and,

(d) It is contractually pre-payable or withdrawal before the stated maturities.

Assets and liabilities which receive / pay interest that vary with a benchmark rate are
re-priced at pre-determined intervals and are rate sensitive at the time of re-pricing.
INTEREST RISK :
The phased deregulation of interest rates and the operational flexibility given to banks in
pricing most of the assets and liabilities imply the need for the banking system to hedge the
Interest-Rate Risk. Interest Rate Risk is the risk where changes in market interest rates
might adversely affect the Bank’s Net Interest Income. The gap report should be generated
by grouping interest rate sensitive liabilities, assets and off balance sheet positions into time
buckets according to residual maturity or next repricing period, whichever is earlier. Interest
rates on term deposits are fixed during their currency while the advance interest rates are
floating rates. The gaps on the assets and liabilities are to be identified on different time
buckets from 1–28 days, 29 days upto 3 months and so on. The interest changes should be
studied vis-a-vis the impact on profitability on different time buckets to assess the interest
rate risk.

GAP ANALYSIS :

The various items of rate sensitive assets and liabilities and off-balance sheet items
are classified into time buckets such as 1-28 days, 29 days and upto 3 months etc. and
items non-sensitive to interest based on the probable date for change in interest.

The gap is the difference between Rate Sensitive Assets (RSA) and Rate Sensitive
Liabilities (RSL) in various time buckets. The positive gap indicates that it has more
RSAS than RSLS whereas the negative gap indicates that it has more RSLS. The gap
reports indicate whether the institution is in a position to benefit from rising interest
rates by having a Positive Gap (RSA > RSL) or whether it is a position to benefit from
declining interest rate by a negative Gap (RSL > RSA).

REPORTS :

The following reports are used for ALM:

• Structual Liquidity Profile (SLP);

• Interest Rate Sensitivity
• Maturity and Position (MAP)
• Statement of Interest Rae Sensitivity (SIR)

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