DESSERTATION WORK

ON

ASSET LIABILITY MANAGEMENT

SUMBITTED TO THE UNIVERSITY OF JAMIA HAMDARD
IN THE PARTIAL FULFILLMENT OF THE DEGREE OF
MASTER OF BUSINESS ADMINISTRATION

SUBMITTED

BY

AMBREEN KAUSAR

UNDER THE GUIDANCE OF

MR.AREEB KHAN

FACULTY OF MANAGEMENT& INFORMATION TECHNOLOGY

JAMIA HAMDARD, NEW DELHI

2009-2011
 DECLARATION

I, the undersigned hereby declared that the Project Report entitled “ASSET LIABILITY
MANAGEMENT” written and submitted by me to the university of JAMIA HAMDARD,
New Delhi in partial fulfilment of the requirement of the award degree of MASTER OF
BUSINESS ADMINISTRATION under the guidance of MR. AREEB KHAN is my original
work and the conclusions drawn therein are based on the materials collected by myself.

AMBREEN KAUSAR

ENRL.NO:- 2009-502-014
 TABLE OF CONTENTS

1. Executive Summary

2. Introduction

3. Review of Literature

4. Asset Liability Management in Banks

5. Asset Liability Information System

i. ALM Organisation

ii. Composition of ALCO

iii. Composition of Directors

iv. ALM Process

6. Organisation Structure of ALM

7. Composition of assets and liabilities in Banks and their management

8. ALM strategies for correcting mismatch

9. Study of ALM in Indian Banks

i. Objectives

ii. Methodology

iii. Reclassification of assets and liabilities

iv. Canonical correlation analysis

v. Observation
 vi. Foreign Banks

vii. Private Banks

viii. Nationalized Banks

ix. SBI& Associates

x. Profitability analysis of Banks

10. Information Technology and ALM in Indian context

11. Reasons for growing significance of ALM

12. Purpose and Objective of ALM

13. Securitisation to reduce ALM gap in Banks by 23% - a report

14. RBI guidelines

15. ALM in Banks – A CASE OF KUWAIT

16. Conclusion

17. Suggestions

18. References

19. DO’S and DONT’S

EXECUTIVE SUMMARY

Bank asset and liability management(ALM), an art as old as banking itself, is a cornerstone
of financial market risk management. Banks and other financial institutions are in the
business of taking on risk, using their expertise in risk valuation to generate return. The types
of risk exposure taken on can be subtle and complex, reflecting not only the individual
products themselves, but also interacting with external factors. Therefore when assessing risk
exposure it is important to consider bank’s balance sheet as a whole. A bank’s ALM
committee (ALCO) will take just this approach managing the banks assets and liabilities and
being responsible for overseeing liquidity and market risk at the highest level.

In managing these risks, no single measurement or ratio gives the complete picture. To assess
the liquidity risk we need to consider the entire balance sheet, as well as off-balance sheet
business. Assessing and managing the market risk is also a complex activity. The two risks
frequently overlap and the ALM discipline recognizes this by overseeing both risks
concurrently.

Changes in market liquidity and or interest rates exposes banks/ business to the risk of loss,
which may, in extreme cases, threaten the survival of institution. As such, it is important that
senior management as well as the Board of Directors must understand the existence of such
risk on the balance sheet and they should ensure that the structure of the institutions’ business
and the level of balance sheet risk it assumes are effectively managed, that appropriate
policies and procedures are established to control and limit these risks, and that resources are
available for evaluating and controlling interest rate risk. Increasingly Asset Liability
Management has become an integral part of Bank Management. Banks’ are exposed to
Balance Sheet Risk, where it is absolutely necessary for the management of the bank to
understand the existence of such risk and best manage the exposure to the risk. The Asset
Liability Committee (ALCO), comprising of the senior management of a bank, is primarily
responsible for Balance Sheet Management or more specifically Balance Sheet Risk
Management.

INTRODUCTION
Asset Liability Management (ALM) defines management of all assets and liabilities (both off
and on balance sheet items) of a bank. It requires assessment of various types of risks and
altering the asset liability portfolio to manage risk. Till the early 1990s, the RBI did the real
banking business and commercial banks were mere executors of what RBI decided. But now,
BIS is standardizing the practices of banks across the globe and India is part of this process.
The success of ALM, Risk Management and Basel Accord introduced by BIS depends on the
efficiency of the management of assets and liabilities. Hence these days without proper
management of assets and liabilities, the survival is at stake. A bank’s liabilities include
deposits, borrowings and capital. On the other side pf the balance sheets are assets which are
loans of various types which banks make to the customer for various purposes. To view the
two sides of banks’ balance sheet as completely integrated units has an intuitive appeal. But
the nature, profitability and risk of constituents of both sides should be similar. The structure
of banks’. balance sheet has direct implications on profitability of banks especially in terms
of Net Interest Margin (NIM). So it is absolute necessary to maintain compatible asset-
liability structure to maintain liquidity, improve profitability and manage risk under
acceptable limits.
 ASSET LIABILITY MANAGEMENT

IT IS A DYNAMIC PROCESS OF PLANNING,

ORGANIZING & CONTROLLING OF ASSETS &
LIABILITIES- THEIR VOLUMES, MIXES,
MATURITIES, YIELD & COSTS IN ORDER TO
MAINTAIN LIQUIDITY & NII.
REVIEW OF LITERATURE

Asset-liability management (ALM) is a term whose meaning has evolved. It is used in

slightly different ways in different contexts. ALM was pioneered by financial institutions, but
corporations now also apply ALM techniques. This article describes ALM as a general
concept, starting with more traditional usage.

Traditionally, banks and insurance companies used accrual accounting for essentially all their
assets and liabilities. They would take on liabilities, such as deposits, life insurance policies
or annuities. They would invest the proceeds from these liabilities in assets such as loans,
bonds or real estate. All assets and liabilities were held at book value. Doing so disguised
possible risks arising from how the assets and liabilities were structured.

Consider a bank that borrows USD 100MM at 3.00% for a year and lends the same money at
3.20% to a highly-rated borrower for 5 years. For simplicity, assume interest rates are
annually compounded and all interest accumulates to the maturity of the respective
obligations. The net transaction appears profitable—the bank is earning a 20 basis point
spread—but it entails considerable risk. At the end of a year, the bank will have to find new
financing for the loan, which will have 4 more years before it matures. If interest rates have
risen, the bank may have to pay a higher rate of interest on the new financing than the fixed
3.20 it is earning on its loan. Suppose, at the end of a year, an applicable 4-year interest rate
is 6.00%. The bank is in serious trouble. It is going to be earning 3.20% on its loan and
paying 6.00% on its financing. Accrual accounting does not recognize the problem. The book
value of the loan (the bank's asset) is:

[1
100MM(1.032) = 103.2MM.
]

The book value of the financing (the bank's liability) is:

[2
100MM(1.030) = 103.0MM.
]

Based upon accrual accounting, the bank earned USD 200,000 in the first year.

Market value accounting recognizes the bank's predicament. The respective market values of
the bank's asset and liability are:
100MM(1.030) = 103.0MM.

From a market-value accounting standpoint, the bank has lost USD 10.28MM.

So which result offers a better portrayal of the bank' situation, the accrual accounting profit or
the market-value accounting loss? The bank is in trouble, and the market-value loss reflects
this. Ultimately, accrual accounting will recognize a similar loss. The bank will have to
secure financing for the loan at the new higher rate, so it will accrue the as-yet unrecognized
loss over the 4 remaining years of the position.

The problem in this example was caused by a mismatch between assets and liabilities. Prior
to the 1970's, such mismatches tended not to be a significant problem. Interest rates in
developed countries experienced only modest fluctuations, so losses due to asset-liability
mismatches were small or trivial. Many firms intentionally mismatched their balance sheets.
Because yield curves were generally upward sloping, banks could earn a spread by borrowing
short and lending long.

Things started to change in the 1970s, which ushered in a period of volatile interest rates that
continued into the early 1980s. US regulation Q, which had capped the interest rates that
banks could pay depositors, was abandoned to stem a migration overseas of the market for
USD deposits. Managers of many firms, who were accustomed to thinking in terms of accrual
accounting, were slow to recognize the emerging risk. Some firms suffered
staggering losses. Because the firms used accrual accounting, the result was not
so much bankruptcies as crippled balance sheets. Firms gradually accrued the
losses over the subsequent 5 or 10 years.

One example is the US mutual life insurance company the Equitable. During the early 1980s,
the USD yield curve was inverted, with short-term interest rates spiking into the high teens.
The Equitable sold a number of long-term guaranteed interest contracts (GICs) guaranteeing
rates of around 16% for periods up to 10 years. During this period, GICs were routinely for
principal of USD 100MM or more. Equitable invested the assets short-term to earn the high
interest rates guaranteed on the contracts. Short-term interest rates soon came down. When
the Equitable had to reinvest, it couldn't get nearly the interest rates it was paying on the
GICs. The firm was crippled. Eventually, it had to demutualize and was acquired by the Axa
Group.

Increasingly, managers of financial firms focused on asset-liability risk. The problem was
not that the value of assets might fall or that the value of liabilities might rise. It was that
capital might be depleted by narrowing of the difference between assets and liabilities—that
the values of assets and liabilities might fail to move in tandem. Asset-liability risk is a
leveraged form of risk. The capital of most financial institutions is small relative to the firm's
assets or liabilities, so small percentage changes in assets or liabilities can translate into large
percentage changes in capital.
Exhibit 1 illustrates the evolution over time of a hypothetical company's assets and liabilities.
Over the period shown, the assets and liabilities change only slightly, but those slight changes
dramatically reduce the company's capital (which, for the purpose of this example, is defined
as the difference between assets and liabilities). In Exhibit 1, the capital falls by over 50%, a
development that would threaten almost any institution.

Example: Asset-Liability Risk

Exhibit 1

Asset-liability risk is leveraged by the fact that

the values of assets and liabilities each tend to
be greater than the value of capital. In this
example, modest fluctuations in values of
assets and liabilities result in a 50% reduction
in capital.

Accrual accounting could disguise the problem by deferring losses into the future, but it
could not solve the problem. Firms responded by forming asset-liability management (ALM)
departments to assess asset-liability risk. They established ALM committees comprised of
senior managers to address the risk.

Techniques for assessing asset-liability risk came to include gap analysis and duration
analysis. These facilitated techniques of gap management and duration matching of assets
and liabilities. Both approaches worked well if assets and liabilities comprised fixed cash
flows. Options, such as those embedded in mortgages or callable debt, posed problems that
gap analysis could not address. Duration analysis could address these in theory, but
implementing sufficiently sophisticated duration measures was problematic. Accordingly,
banks and insurance companies also performed scenario analysis.

With scenario analysis, several interest rate scenarios would be specified for the next 5 or 10
years. These might assume declining rates, rising rate's, a gradual decrease in rates followed
by a sudden rise, etc. Scenarios might specify the behavior of the entire yield curve, so there
could be scenarios with flattening yield curves, inverted yield curves, etc. Ten or twenty
scenarios might be specified in all. Next, assumptions would be made about the performance

of assets and liabilities under each scenario. Assumptions might include prepayment rates on
mortgages or surrender rates on insurance products. Assumptions might also be made about
the firm's performance—the rates at which new business would be acquired for various
products. Based upon these assumptions, the performance of the firm's balance sheet could be
projected under each scenario. If projected performance was poor under specific scenarios,
the ALM committee might adjust assets or liabilities to address the indicated exposure. A
shortcoming of scenario analysis is the fact that it is highly dependent on the choice of
scenarios. It also requires that many assumptions be made about how specific assets or
liabilities will perform under specific scenarios.

In a sense, ALM was a substitute for market-value accounting in a context of accrual

accounting. It was a necessary substitute because many of the assets and liabilities of
financial institutions could not—and still cannot—be marked to market. This spirit of market-
value accounting was not a complete solution. A firm can earn significant mark-to-market
profits but go bankrupt due to inadequate cash flow. Some techniques of ALM—such as
duration analysis—do not address liquidity issues at all. Others are compatible with cash-
flow analysis. With minimal modification, a gap analysis can be used for cash flow analysis.
Scenario analysis can easily be used to assess liquidity risk.

Firms recognized a potential for liquidity risks to be overlooked in ALM analyses. They also
recognized that many of the tools used by ALM departments could easily be applied to assess
liquidity risk. Accordingly, the assessment and management of liquidity risk became a second
function of ALM departments and ALM committees. Today, liquidity risk management is
generally considered a part of ALM.

ALM has evolved since the early 1980's. Today, financial firms are increasingly using
market-value accounting for certain business lines. This is true of universal banks that have
trading operations. For trading books, techniques of market risk management—value-at-risk
(VaR), market risk limits, etc.—are more appropriate than techniques of ALM. In financial
firms, ALM is associated with those assets and liabilities—those business lines—that are
accounted for on an accrual basis. This includes bank lending and deposit taking. It includes
essentially all traditional insurance activities.

Techniques of ALM have also evolved. The growth of OTC derivatives markets have
facilitated a variety of hedging strategies. A significant development has been securitization,
which allows firms to directly address asset-liability risk by removing assets or liabilities
from their balance sheets. This not only reduces asset-liability risk; it also frees up the
balance sheet for new business.

The scope of ALM activities has widened. Today, ALM departments are addressing (non-
trading) foreign exchange risks and other risks. Also, ALM has extended to non-financial
firms. Corporations have adopted techniques of ALM to address interest-rate exposures,
liquidity risk and foreign exchange risk. They are using related techniques to address
commodities risks. For example, airlines' hedging of fuel prices or manufacturers' hedging of
steel prices are often presented as ALM.

ASSET LIABILITY MANAGEMENT IN BANKS

Over the last few years the Indian financial markets have witnessed wide ranging changes at
fast pace. Intense competition for business involving both the assets and liabilities, together
with increasing volatility in the domestic interest rates as well as foreign exchange rates, has
brought pressure on the management of banks to maintain a good balance among spreads,
profitability and long-term viability. These pressures call for structured and comprehensive
measures and not just ad hoc action. The Management of banks has to base their business
decisions on a dynamic and integrated risk management system and process, driven by
corporate strategy. Banks are exposed to several major risks in the course of their business -
credit risk, interest rate risk, foreign exchange risk, equity / commodity price risk, liquidity
risk and operational risks.

This note lays down broad guidelines in respect of interest rate and liquidity risks
management systems in banks which form part of the Asset-Liability Management (ALM)
function. The initial focus of the ALM function would be to enforce the risk management
discipline viz. managing business after assessing the risks involved. The objective of good
risk management programmes should be that these programmes will evolve into a strategic
tool for bank management.

The ALM process rests on three pillars:

• ALM information systems

=> Management Information System
=> Information availability, accuracy, adequacy and expediency

• ALM organisation
=> Structure and responsibilities
=> Level of top management involvement

• ALM process
=> Risk parameters
=> Risk identification
=> Risk measurement
=> Risk management
=> Risk policies and tolerance levels.

ALM information systems

Information is the key to the ALM process. Considering the large network of branches and
the lack of an adequate system to collect information required for ALM which analyses
information on the basis of residual maturity and behavioural pattern it will take time for
banks in the present state to get the requisite information. The problem of ALM needs to be
addressed by following an ABC approach i.e. analysing the behaviour of asset and liability
products in the top branches accounting for significant business and then making rational
assumptions about the way in which assets and liabilities would behave in other branches. In
respect of foreign exchange, investment portfolio and money market operations, in view of
the centralised nature of the functions, it would be much easier to collect reliable information.
The data and assumptions can then be refined over time as the bank management gain
experience of conducting business within an ALM framework. The spread of computerisation
will also help banks in accessing data.

ALM organisation
a) The Board should have overall responsibility for management of risks and should
decide the risk management policy of the bank and set limits for liquidity, interest rate,
foreign exchange and equity price risks.
b) The Asset - Liability Committee (ALCO) consisting of the bank's senior management
including CEO should be responsible for ensuring adherence to the limits set by the Board as
well as for deciding the business strategy of the bank (on the assets and liabilities sides) in
line with the bank's budget and decided risk management objectives.
c) The ALM desk consisting of operating staff should be responsible for analysing,
monitoring and reporting the risk profiles to the ALCO. The staff should also prepare
forecasts (simulations) showing the effects of various possible changes in market conditions
related to the balance sheet and recommend the action needed to adhere to bank's internal
limits.

The ALCO is a decision making unit responsible for balance sheet planning from risk -
return perspective including the strategic management of interest rate and liquidity risks.
Eachbank will have to decide on the role of its ALCO, its responsibility as also the decisions
to be taken by it. The business and risk management strategy of the bank should ensure that
the bank operates within the limits / parameters set by the Board. The business issues that an
ALCO would consider, inter alia, will include product pricing for both deposits and advances,
desired maturity profile of the incremental assets and liabilities, etc. In addition to monitoring
the risk levels of the bank, the ALCO should review the results of and progress in
implementation of the decisions made in the previous meetings. The ALCO would also
articulate the current interest rate view of the bank and base its decisions for future business
strategy on this view. In respect of the funding policy, for instance, its responsibility would
be to decide on source and mix of liabilities or sale of assets. Towards this end, it will have to
develop a view on future direction of interest rate movements and decide on a funding mix
between fixed vs floating rate funds, wholesale vs retail deposits, money market vs capital market
funding, domestic vs foreign currency funding, etc. Individual banks will have to decide the
frequency for holding their ALCO meetings.

Composition of ALCO
The size (number of members) of ALCO would depend on the size of each institution,
business mix and organisational complexity. To ensure commitment of the Top Management,
the CEO/CMD or ED should head the Committee. The Chiefs of Investment, Credit, Funds
Management / Treasury (forex and domestic), International Banking and Economic Research
can be members of the Committee. In addition the Head of the Information Technology
Division should also be an invitee for building up of MIS and related computerisation. Some
banks may even have sub-committees.

Committee of Directors
Banks should also constitute a professional Managerial and Supervisory Committee
consisting of three to four directors which will oversee the implementation of the system and
review its functioning periodically.

ALM process
The scope of ALM function can be described as follows:
• Liquidity risk management
• Management of market risks
(including Interest Rate Risk)
• Funding and capital planning
• Profit planning and growth projection
• Trading risk management

ORGANISATIONAL STRUCTURE OF ALM

CEO Managing Director

Head of Consumer Banking

Head of Treasury
Head of Corporate Banking Head of ALM

Head of Finance Treasury

Head of Credit Money Market Dealers Responsible

Head of Operations of ALM

COMPONENTS OF ASSET’S & LIABILITIES IN BANK’S

BALANCE SHEET & THEIR MANAGEMENT

Banks liabilities:-

The sources of funds for the lending and investment activities constitute liabilities side of the
balance sheet.

Capital

Reserves & Surplus

Deposits

Borrowings

Other liabilities & Provisions

Contigent Liabilities

Banks assets:-

Are the funds mobilised by banks through various sources.

Cash and Bank balances with Reserve Bank of India.

Balances with banks and money at call and short notice.

Investments

Advances

Fixed Assets

Other Assets

ALM is about management of Net Interest Margin (NIM) to ensure that its level and riskiness
are compatible with risk/return objectives of bank. It is more than just managing individual
assets and liabilities. It is an integrated approach to banks financial management requiring
simultaneous decision about types and amount of financial assets and liabilities it holds or its
mix and volume. In addition ALM requires an understanding of the market area in which
bank operates.

If 50% of the liabilities are maturing within 1 year but only 10% of the assets are maturing
within the same period. Though, the financial institution has enough assets, it may become
temporarily insolvent due to a severe liquidity crisis.
 THUS , ALM IS REQUIRED TO MATCH ASSETS AND LIABILITIES AND
MINIMISE LIQUIDITY AS WELL AS MARKET RISK.

Asset-liability management
strategies for correcting mismatch

The strategies that can be employed for correcting the mismatch in terms of D(A)> D(L) can
be either liability or asset driven. Asset driven strategies for correcting the mismatch focus on
shortening the duration of the asset portfolio. The commonlyemployed asset based financing
strategy is securitization. Typically the long-term asset portfolios like the lease and hire
purchase portfolios aresecuritized; and the resulting proceeds are either redeployed in short
term assets or utilized for repaying short-term liabilities. Liability driven strategies basically
focus on lengthening the maturity profiles of liabilities. Such strategies can include for
instance issue of external equity in the form of additional equity shares or compulsorily
convertible preference shares (which can also help in augmenting the Tier I capital of finance
companies), issue of redeemable preference shares, subordinated debt instruments,debentures
and accessing long term debt like bank borrowings and term loans. Strategies to be
employed for correcting a mismatch in the form of D(A) < D(L) (which will be
necessary if interest rates are expected to decline) will be the reverse of the strategies
discussed above.
Asset driven strategies focus on lengthening the maturity profile of assets by the deployment
of available lendable resources in long-term assets such as lease andhire purchase. Liability
driven strategies focus on shortening the maturity profile of liabilities, which can include,
liquidating bank borrowings which are primarily in the form of cash credit (and hence
amenable for immediate liquidation), using the prepayment options (if any embedded in the
term loans); and the call options, if any embedded in bonds issued by the company; and
raising short-term borrowings (e.g.: fixed deposits with a tenor of one year) to repay long-
term borrowings.

STUDY OF ASSET LIABILITY MANAGEMENT

IN INDIAN BANKS

ALM MODELS

Analytical models are very important for ALM analysis and scientific decision making. The
basic models are:

1. GAP Analysis Model

2. Duration GAP Analysis Model

3. Scenario Analysis Model

4. Value at Risk (VaR) model

5. Stochastic Programming Model

Any of these models is being used by banks through their Asset Liability Management
Committee (ALCO). The Executive Director and other vital departments’ heads head ALCO
in banks. There are minimum four members and maximum eight members. It is responsible
for Responsible for Setting business policies and strategies, Pricing assets and liabilities,
Measuring risk, Periodic review, Discussing new products and Reporting.

OBJECTIVES OF THE STUDY

Though Basel Capital Accord and subsequent RBI guidelines have given a structure for ALM
in banks, the Indian Banking system has not enforced the guidelines in total. The banks
have formed ALCO as per the guidelines; but they rarely meet to take decisions. Public
Sector banks are yet to collect 100% of ALM data because of lack of computerization in all
branches. With this background, this research aims to find out the status of Asset Liability
Management across all commercial banks in India with the help of multivariate technique of
canonical correlation. The discussion paper has following objectives to explore:

• To study the Portfolio-Matching behavior of Indian Banks in terms of nature and strengths
of relationship between Assets and Liability

• To find out the component of Assets explaining variance in Liability and viceversa

• To study the impact of ownership over Asset Liability management in Banks

• To study impact of ALM on the profitability of different bank-groups

METHODOLOGY

The study covers all scheduled commercial banks except the RRBs (Regional Rural Banks).

The period of the study was from 1992 – 2004. The banks were grouped based on
ownership structure. The groups were

1. Nationalized Banks except SBI & Associates ( 19 )

2. SBI and Associates ( 8)

3. Private Banks( 30)

4. Foreign Banks(36)
 RECLASSIFICATION OF ASSETS &
LIABILITIES
The assets and liabilities of a Bank are divided into various sub heads. For the purpose of
the study, the assets were regrouped under six major heads and the liabilities were
regrouped under four major heads as shown in table below. This classification is guided by
prior information on the liquidity-return profile of assets and the maturity-cost profile of
liabilities. The reclassified assets and liabilities covered in the study exclude ‘other assets’ on
the asset side and ‘other liabilities’ on the liabilities side. This is necessary to deal with the
problem of singularity

– a situation that produces perfect correlation within sets and makes correlation between
sets meaningless. The relevant data has been collected from the RBI website.
CANONICAL CORRELATION ANALYSIS
Multivariate statistical technique, canonical correlation has been used to access the nature
and strength of relationship between the assets and liabilities. To explore the relationship
between assets and liabilities, we could merely compute the correlation between each set of
assets and each set of liabilities. Unfortunately, all of these correlations assess the same
hypothesis - that assets influence liabilities. Hence, a Bonferroni adjustment needs to be
applied. That is, we should divide the level of significance by the number of correlations. This
Bonferroni adjustment, of course, reduces the power of each correlation and thus can
obscure the findings. Canonical correlation provides a means to explore all of the
correlations concurrently andthus obviates the need to incorporate a Bonferroni adjustment.
The technique reduces the relationship into a few significant relationships.The essence of
canonical correlation Measures the strength of relationship between two sets of variables
(Assets (6) & Liabilities (4) in this case) by establishing linear combination of variables in one
set and a linear combinations of variables in other set. It produces an output that shows the
strength of relationship between two variates as well as individual variables accounting for
variance in other set

A = A1 * (Liquid Assets) + A2 * (SLR Securities)+ A3 * (Investments) + A4 * (Term Loans) +

A5 *

(Short Term Loans) + A6 * (Fixed Assets)

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

Deposits)

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

Foreign Banks Pvt Banks Nationalised SBI & Associates

Banks
R square 0.948 0.997 0.987 0.998
Canonical
Loadings
Assets
LA 0.243 0.716 -0.046 0.237
SLR 0.078 0.712 -0.328 0.744
INV 0.314 -0.467 -0.662 0.858
TL -0.469 -0.464 0.188 0.568
STL 0.268 0.461 0.747 -0.88
FA -0.903 -0.945 -0.728 0.644
Liabilities
NW -0.664 -0.948 -0.885 0.831
BOR 0.171 -0.523 0.593 -0.83
STD 0.498 0.972 0.126 -0.457
LTD -0.255 -0.201 0.007 0.964

Redundancy
Asset 0.212 0.426 0.279 0.476
Liability 0.196 0.539 0.288 0.629

The first row (R2) is a measure of the significance of the correlation. In this case all the
correlations are significant. The canonical loading is a measure of the strength of the
association i.e. it is the percent of variance linearly shared by an original variable with one of
the canonical variates. A loading greater that 40% is assumed to be significant. A negative
loading indicates an inverse relationship. For example, for Foreign Banks, Fixed Assets (FA)
under Assets has a loading of -0.903 and Net Worth (NW) under liabilities has a loading of

-0.664. Since both are negative this means there is a strong correlation between FA and
NW. Similarly for Foreign Banks, we can observe that there is a strong negative correlation
betweenshort term deposit with both Term Loan and Fixed Asset.
OBSERVATIONS

As per the summary table above, the canonical co-relation coefficients of different set of
banks indicate that different banks have different degree of association among constituents
of assets and liabilities. Bank-Groups can be arranged in decreasing order of correlation:

– SBI & Associates

– Private Banks

– Nationalized Banks

– Foreign Banks

Redundancy factors indicate how redundant one set of variables is, given the other set of
variable which gives an idea about independent and dependent sets. This also gives an idea
about the fact that whether the bank is asset managed or liability managed. Looking at the
redundancy factors, the independent and dependent sets for different bank- groups can be
identified:
Other than foreign bank groups, all other three have asset as their independent set. This
means during the study period (1992-2004), these banks were actively managing assets and
liability was dependent upon how well the assets are managed. This is in perfect consonance
with the macro indicators. The interest rates were coming down all these years and banks
were busy in parking their assets in different avenues where they could get maximum return.
Lately, the scenario has changed in terms of interest rates. Now as there is ample liquidity in
the market, banks especially the bigger one is not concerned about the liability. They can
always borrow from active money market to manage their liability.

Foreign Banks
The canonical function coefficient or the canonical weight of different constituents in case of
foreign banks Term Loans and Fixed Assets form asset side and Net Worth and Short Term
Deposit from liability side have significant presence with following interpretation:

• Very strong co-relation between Fixed Assetand Net Worth.

• Strong negative correlation between short term deposit with both Term Loan and Fixed
Asset. This indicates-

• Proper usage of short term deposit.

• Not used for long term assets or long term loans.

Private Banks

In case of private banks all constituents of asset side Liquid Assets, SLR Securities, Short
Term Loans, Investments, Term Loans, and Fixed Asset are significantly explaining the co-
relation while on liability side only Net Worth and Short Term Deposit are contributing. This
shows how actively these banks manage their asset to generate maximum return. This
relationship can

be interpreted in the following ways:

• Very strong co-relation between FA and NW.

• Short Term Deposits is used for Liquid Assets, SLR and Short Term Loans. As defined
above LA, SLR and STL – all are highly liquid section of assets. So it is very prudent to
employ short term deposit.

• Borrowings are used for Investment and Term Loans. As defined, borrowings are near
maturity liability while investment and term loans are of long term maturity. So the private
banks are using risky strategy of deploying short term fund in long term investment which is
clearly against right

asset-liability management. Under normal circumstances long term investment gives better
returns, so this strategy is to generate additional profitability at the cost of liquidity. However
as the money market has become more matured, it is easy to manage liquidity without much
of risk.
Nationalized Banks

In case of nationalized banks Investment, short term loan, fixed asset contribute significantly
in explaining asset part while net worth and borrowings constituent of liability is major
factor.

The major interpretations are:

• Very strong co-relation between FA and NW.

• Nationalized banks use Borrowings for Short Term Loans.

• There is negative co-relation between Borrowings and investment.

• More concerned with liquidity than profitability

• Conservative strategy ( in comparison toPrivate Banks)

• Good short term maturity/liquidity management

Nationalized banks use a borrowing (which is near term maturity) for short term a loan which
is effective way of ALM. However nationalized banks deploy long term liability in short term
assets. This is distinctly different from private banks strategy. The nationalized banks are
more concerned about liquidity than profitability.

SBI & Associates

For SBI group all constituents of Liability namely Net worth, borrowings, short term deposits
and long term deposits are significant while in assets side SLR investment, Investments,
Term loans and fixed assets are significant. Following can be interpreted:

• Very strong correlation between FA and NW

• Strong correlation between Borrowings and STL.

• Correlation between Long term Deposits and ‘Term Loans, Investment and SLR’.

• Short Term Deposits and Short Term Liabilities are correlated.

• Most Conservative strategy

• Over concerned with liquidity

• Use Long term funds for Long as well as

medium & short term loans Among all bank-groups, SBI & Associates seem to be most
prudent asset liability management as short term liability is matched with short term asset and
long term assets is matched with long term liability. But at the same time, this group deploy
long term fund for medium and short term loans. This can be called over concerned with
liquidity and that too by paying a price in terms of less profitability by foregoing the
opportunity to deploy them in long term assets.

PROFITABILITY ANALYSIS OF BANKS

As discussed above, private banks are more aggressive in managing their portfolio for better
profit realization. So let us look into the profitability of these banks and relate that to their
ALM. For this all banks are divided into two groups- Public and Private. Nationalized along
with SBI are clubbed together as public banks while foreign and private banks are clubbed
together as private banks. The profit figures can be compared in terms of Net Profit Margin,
Return on Net Worth and Equity Multiplier. Following graph depicts the comparison The
above comparison shows that till 2002, private banks were better in terms of profitability
indicators. The aggressive strategy adopted by them in terms of deploying asset for long term
is being reflected in the better profitability as compared to public sector banks. Since 2002,
the public banks have caught up with private banks. This can be due to second generation
banking reforms, deregulation and more autonomy given to the banks in terms of directed
credit and regulated interest rates.

NET PROFIT MARGIN (%)

16

14

12

10
Public
8
Private
6

0
1995

1997

1999

2001

2002

2003

2004
1996

1998

2000

RETURN ON NET WORTH (%)

 10
15
20
25
30

0
5
1995

1996

1997

1998

1999

2000

2001

2002

2003

2004
Public
Private
Information technology and asset-liability
management in the Indian context:-

Many of the new private sector banks and some of the non-banking financial companies have
gone in for complete computerization of their branch network and have also integrated their
treasury, forex, and lending segments. The information technology initiatives of these
institutions provide significant advantage to them in asset-liability management since it
facilitates faster flow of information, which is accurate and reliable. It also helps in terms of
quicker decision-making from the central office since branches are networked and accounts
are considered as belonging to the bank rather than a branch.

The electronic fund transfer system as well as demat holding of securities also significantly
alters mechanisms of implementing asset-liability management because trading, transaction,
and holding costs get reduced. Simulation models are relatively easier to consider in the
context of networking and also computing powers. The open architecture, which is evolving
in the financial system, facilitates cross-bank initiatives in asset-liability management to
reduce aggregate unit cost. This would prove as a reliable risk reduction mechanism. In other
words, the boundaries of asset-liability management architecture itself is changing because of
substantial changes brought about by information technology, and to that extent the
operations managers are provided with multiple possibilities which were not earlier available
in the context of large numbers of branch networks and associated problems of information
collection, storage, and retrieval.

In the Indian context, asset-liability management refers to the management of deposits, credit,
investments, borrowing, forex reserves and capital, keeping in mind the capital adequacy
norms laid down by the regulatory authorities. Information technology can facilitate decisions
on the following issues: . Estimating the main sources of funds like core deposits, certificates
of deposits, and call borrowings. . Reducing the gap between rate sensitive assets and rate
sensitive liabilities, given a certain level of risk. . Reducing the maturity mismatch so as to
avoid liquidity problems. . Managing funds with respect to crucial factors like size and
duration.
 REASONS FOR GROWING SIGNIFICANCE OF
ALM

-Volatility
- Product Innovation
- Regulatory Framework
- Management Recognition

An effective Asset Liability Management technique aims to manage the volume mix,
maturity,rate sensitivity, quality and liquidity of assets and liabilities as a whole
so as to attain a predetermined acceptabl risk/reward ratio.

PURPOSE AND OBJECTIVES OF ASSET

LIABILITY MANAGEMENT

 Review the interest rate structure and compare the same to the interest/product pricing
of both assets and liabilities.
 Examine the loan and investment portfolios in the light of the foreign exchange risk
and liquidity risk that might arise.
 Examine the credit risk and contingency risk that may originate either due to rate
fluctuations or otherwise and assess the quality of assets.

 Review,the actual performance against the projections made and analyse the reasons
for any effect on spreads.
 Aim is to stabilise the short-term profits,long-term earnings and long-term substance
of the bank.The parameters that are selected for the purpose of stabilising asset
liability management of banks are:
-Net Interest Income(NII)

-Net Interest Margin(NIM)

-Economic Equity Ratio
Net Interest Income- Interest Income-Interest Expenses.
Net Interest Margin- Net InterestIncome/Average Total Assets

Economic Equity Ratio-

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

Securitisation To Reduce ALM Gap In Banks By

23%

: Securitisation, as a financial management tool, offers multifarious advantages to banks in areas

like exposure management and capital management. Banks can also use securitisation to
generate profits from interest rate arbitrage and as an alternative funding source. But there is
another key benefit that banks can enjoy from securitisation: the management of their asset
liability maturity (ALM) profile.

By nature, the banking business is characterised by shorter-term liabilities funding relatively

longer-term assets, which engenders a mismatch in the players’ structural ALM profile. Although
the stickiness and stability of the banks’ liability profile largely mitigates this risk, securitisation
offers a potent ALM management tool as banks can substitute assets having a finite maturity
period with cash on their balance sheets.

Crisil’s analysis reveals that on a three-year horizon, the banking

system’s maturing liabilities exceed its maturing assets by
around 17 per cent. Securitisation can reduce this gap by as
much as 23.4 per cent. Besides, securitisation also allows banks
to transfer some maturity-related risks like prepayment and
conversion risks to third-party investors.

Introduction

Securitisation refers to the conversion of cash flows into

marketable securities. It is a process through which illiquid
assets are packaged, converted into tradable securities and sold
to third-party investors. Such securities are called asset-backed
securities (ABS). Typically, these instruments are highly rated
and carry a variety of credit enhancement mechanisms. If the
underlying assets are themselves of a very high credit quality or
if a high credit rating on the ABS is not essential, the extent of
credit enhancement may be minimal or non-existent.

Depending on the type of receivables securitised, the resulting instrument is referred to as

mortgage-backed securities (MBS) in the case of housing loans, collateralised bond obligations
(CBO) in the case of bond receivables and collateralised loan obligations (CLO) in the case of
industrial loan receivables. Collateralised debt obligations (CDO) are a hybrid of CLOs and CBOs
as they refer to securitisations backed by a combination of bond and industrial loan receivables.

Reducing ALM Mismatches

Since securitisation is a source of immediate liquidity, banks can effectively use it to manage
balance sheets that have a higher average maturity of assets than liabilities. By replacing assets
having a pre-determined cash flow schedule spread over time with cash, securitisation shortens
the average maturity of assets, thus improving the banks’ ALM profile. Managing structural
liquidity is a key element of the banks’ risk management strategies and securitisation is a robust
tool that enables them to effectively do just that.
For instance, let us consider a hypothetical scenario whereby a bank with a balance sheet size of
Rs 100 has a negative ALM gap of 29 per cent in the zero-to-three-year maturity bucket. After
securitising loans and advances worth Rs14, whereby an equivalent amount of loans and
advances in the greater-than-three-year maturity bucket are substituted by cash, the negative
ALM is reduced by nearly 50 per cent to 15 per cent, thus substantially improving the bank’s
ALM profile.

Estimation Of Benefits To Banks’ ALM Profile

Crisil has analysed the ALM profile of the Indian banking system by segmenting banks into the
following categories:

1. State Bank of India and its associate banks

2. Other nationalised banks
3. New private sector banks
4. Foreign banks, and
5. Older private sector banks

On the whole, the banking system’s total assets amounted to Rs 16,989 billion as at March 31,
2003, according to Report on Trend and Progress of Banking in India 2002-03 published by the
Reserve Bank of India. An analysis of the ALM profile of the various bank categories reveals that
there is a negative gap of around 17 per cent of the total assets for a three-year time horizon.
This means that liabilities maturing in three years exceed assets maturing in this period to that
extent.

Deposits, which constitute around 80 per cent of the banks’ balance sheet size, are largely sticky
and have high renewal levels. Hence, the effective mismatch in the banks’ ALM profile would be
considerably lower. On the other hand, if we exclude foreign banks, the negative ALM gap
increases to 19.3 per cent. This is because foreign banks have a relatively more comfortable
ALM profile than Indian banks on account of their higher networth levels, which get classified in
the longest maturity bucket and hence, provide comfort to the ALM profile. The networth to total
assets ratio for foreign banks is 11.5 per cent as compared to 5.8 per cent for the overall banking
system.

The segmental distribution of the ALM gap reveals that across bank categories there is a
negative gap, that is, they have a higher quantum of liabilities maturing in the zero-to-three-year
bucket than assets. Securitisation can be one option to manage this gap.

Crisil has identified the following asset classes from the banks’ overall asset composition as
those that lend themselves to securitisation:

1. Non-performing assets (NPA)

2. Investments in bonds and industrial loans (through CBOs, CLOs and CDOs)
3. Credit card receivables
4. Housing, car and employee loan receivables
Further, Crisil has analysed the asset composition of the various bank categories. It estimates
that foreign and new private sector banks have the highest potential for securitisation at 10-12
per cent of their asset base as compared to an overall securitisation potential of 4 per cent for
the banking system.

This is essentially based on the relative asset composition of the various bank categories, the
relative securitisation potential of these asset classes, the banks’ track record in originating
securitisation transactions and the internal monitoring systems developed by them to track such
transactions.

According to Crisil’s estimate, the banking system has a securitisation potential of over Rs 600
billion. In estimating the quantum of benefits that the ALM profile can derive from this, Crisil
compared the existing ALM gaps of the various bank categories with the estimated gap after
securitisation. This was simulated by assuming that the securitised assets were replaced by cash
on the banks’ balance sheets, which, in turn, shortened the average maturity profile of their asset
books. The analysis reveals that the ALM gap falls for all categories of banks.

The benefit on the ALM profile ranges from 9 per cent for old private sector banks and
nationalised banks to 63 per cent for new private sector banks. This is largely because of the
higher securitisation potential envisaged for new private sector banks by Crisil. For the banking
system as a whole, this benefit is estimated at 23.4 per cent.

Mitigation Of Prepayment And Conversion Risks

Apart from enabling them to reduce their ALM gap, securitisation also helps bank to manage the
risks emanating on their balance sheet on account of prepayment and conversion of loans and
advances. In a declining interest rate scenario, prepayments lower a bank’s interest income as it
would need to deploy prepaid amounts at lower interest rates. Further, in such a scenario, there
is the added pressure of the conversion of higher interest rate loans to lower interest rate ones,
which has a similar effect as prepayments on the bank’s future income streams.

If securitisation is structured in such a manner that the prepayment and conversion risks are
completely passed on to third-party investors, they are mitigated for the concerned bank. Such
securitisation transactions are yet to make a mark in India, however, and are mainly practiced in
developed financial markets like the US and Europe.

The Road Ahead For Banks

Thus, Crisil’s analysis clearly shows that the banking system stands to benefit from securitisation
in terms of obtaining ALM benefits and mitigating prepayment and conversion risks.

Crisil believes that while the new private sector and foreign banks would initially take the lead in
increasingly using securitisation as an alternative financial management technique, other banks
that have so far been conspicuous by their absence from the segment would also begin to look
at it more favourably in terms of managing their ALM profile.

Initially, however, the management of capital structure is expected to be the key driver of
securitisations. This trend would essentially be driven by the growing awareness of securitisation
in the Indian financial markets, the thrust provided by the Securitisation and Reconstruction of
Financial Assets and Enfor-cement of Security Interest Act and the other benefits provided by
securitisation itself such as exposure management and managing the profit and loss account and
balance sheet.

RBI GUIDELINES

 GROUP LIKELY INFLOWS AND OUTFLOWS INTO DIFFERENT TIME

BUCKETS AND PRESCRIBING MAX MISMATCH IN NEAR TERM BUCKETS

1 DAY 5%
2-7 DAYS 10%
8-14 DAYS 15%
5-28 DAYS 20%
PERCENTAGES ARE MAX. FOR RESPECTIVE TIME BUCKET
Assets-liabilities management in banks—a
case of Kuwait
Indian Journal of Economics and Business, June, 2007 by
Batool K. Asiri
Abstract

The Statistical Cost Accounting (SCA) method is used to test whether asset and liability of a
bank could help forecast its profits. All Kuwaiti Listed Banks have been examined over the
period 1980-1997 for the asset-liability relationship. Considering the size difference, the
sample was divided into sub-samples. The study concluded that asset, mainly loans, are the
key variable in generating profits whereas liabilities ate reducing profit. It also proved that a
bank's profits are positively related to risk. In managing asset-liability, the results highlight a
significant difference between small and large banks and between before and after the Gulf
war.

Keywords: Statistical Cost Accounting, Asset-liability management, size effect, Kuwait

I. INTRODUCTION

The Statistical Cost Accounting (SCA) method is used to test whether assets and liabilities of
a bank can in fact help forecast its profits. Gup and Brooks (1993) argued that "asset and
liability management in banks is defined as the simultaneous planning of all asset and
liability positions on the bank's balance sheet under consideration of the different bank
management objectives and legal, managerial and market constraints, for the purpose of
mitigating interest rate risk, providing liquidity and enhancing the value of the bank."

Due to the competition in the financial markets, banks seek out greater efficiency in the
management of their assets and liabilities. The core issue of Asset-Liablity Management
(ALM) is the bank's balance sheet and the main question is: Given a certain level of risk,
government regulation, globalization, competitors, alternative choices of investment, liquidity
and interest rate changes in the market, what should be the composition of a bank's assets and
liablities in order to maximize the bank's profit? What should be the optimal combination of
ALM? These are the two questions raised by Kosmidou et al (2004) who argued that the
optimal balance between these factors cannot be found without considering important
interactions that exist between the structure of a bank's liability and capital and the
compositions of its assets.

Accurately evaluating and measuring the performance of commercial banks is not an easy
task. Banks differ in their sizes and this will have an effect on responsibilities of
management, liquidity, debt level and profitability. A bank's assets and liabilities will affect
its valuation in the market, its ability to acquire other banks or to be acquired at a good price.
Therefore, a complete picture of the bank, in the form of its financial position, i.e. its balance
sheet, should be studied and evaluated to be able to acceptably predict its future performance.
Profits generated by listed banks always give positive signals to the stock market, and hence
help to achieve the main goal of a bank, which is maximizing its wealth for shareholders. The
main source of profits generated by a bank is the balance sheet portfolio: the assets,
liabilities, and capital which are considered important components in determining profits.

The aim of this study is to develop models for assets-liability management as a

risk-return management of the banking industry in Kuwait. In another words, the
operating profit will be examined to see how it is determined together with
determining what factors from the balance sheet create the profits of the bank
and what factors deteriorate it. Since the balance sheet is composed of assets
and liabilities, this means that we are talking about rate of return on assets and
cost of borrowing on liabilities. Therefore, the risk and return concept is also
significant at this stage because banks are tested to see whether they are a "risk
machine" or not. This means that a bank is expected to take risk and transform it
to services, products and then profits. The study investigates risk factors such as
liquidity, credit and capital risk that mostly derive profits (these are explained in
the next section). The risk-return relationship in the banking industry will affect
its valuation in the market. Fraser and Fraser (1991) argued that decisions,
which increase the profitability of the bank without increasing its risk, would
obviously make the bank more valuable to its shareholders. Similarly, decisions
which reduce the risk of the bank without reducing its profitability will also
increase the value of the shareholder wealth. Therefore, all decisions made by
management have an effect on risk and returns.

Fraser and Fraser (1991) argued that the financial performance of commercial
banking is better if its profit is high and its risk is low. But since, generally,
investors are assumed to be risk averse, high profit to them means accepting
high risk. Therefore, management should have a good trade-off between risk and
return. Management should always ask questions about the level of returns
generated compared to the level of risk taken. The most common ratios that
measure the level of risk in the banking industry ate categorized into: Credit risk,
Capital risk and Liquidity risk. A brief explanation for each level of risk is given
below.

Liquidity Risk: Liquid assets are used to measure the size of available cash and near cash
assets to meet the withdrawal demand. This demand could be demand for loans, withdrawals
of demand deposits and opportunities for investments in securities. Failure to provide
adequate liquidity to meet the demands of depositors of creditors can cause a shut down of a
bank within a short period. The ratio is measured as: "Liquidity Risk = Liquid assets /
Deposits". Generally it is expected that the higher the ratio, the lower the risk of liquidity and
the lower the opportunity for profit. The reason for a decline in the profit is that banks forfeit
investing into long-term securities and giving loans.

Credit Risk: Credit risk can be calculated by the ratio of "loans to total assets". In other
words, it measures the risk of interest or principal on loans that will not be paid. Fraser and
Fraser (1991) suggested "Medium Loan / Total Assets". Again reducing credit risk means
giving less loans and therefore the bank suffers from the lower return. In this study we use
total loans rather than medium loans since it is difficult to categorize the size of loans.
Therefore, our ratio is defined as: "Credit Risk = Loans / Total Assets".

Capital Risk: This type of risk can be calculated with the ratio of "equity to total assets" and
explains how much a bank's asset values may decline before the position of its depositors and
other creditors is jeopardized. High ratio of capital to assets means lower degree of risk. This
ratio is defined as: "Capital Risk = Equity / Total Assets"

II. CHARACTERISTICS OF BANKING INDUSTRY IN KUWAIT

Kuwait is a member of the World Bank's International Bank for Reconstruction and
Development (IBRD), the International Finance Corporation (IFC) and the Multilateral
Investment Guarantee Agency. As a result of speculative bubbles in the history of Kuwait
and the crash of the unofficial "Souk Al-Manakh" stock market, the banks were left with
large portfolios of non-performing loans. The situation of the banking sector has worsened
following the invasion of Kuwait by the Iraqi regime in 1990.

The government has since intervened to rescue the financial system through the "Difficult
Debt Settlement Program". Under this scheme, non-performing loans were swapped for
government debt bonds for maturities ranging from ten to twenty years. As a result,
profitability of banks might have been affected by the fact that government debt bonds could
not be traded or discounted. In addition, the debt settlement problem has increased the banks'
risk aversion to large lending operations and hence might have deprived them from profitable
opportunities.

Another most important feature of Kuwaiti banks is the mixed nature of their ownership.
Except for National Bank of Kuwait (NBK), which is almost entirely owned by the private
sector, the government is one of the shareholders in the rest of the banks. The joint ownership
of banks and the reputation of the government as a rescuer of the last resort, may have
contributed to bank's misbehavior.
Overall, the country's banking industry is fundamentally sound and commercial banks are
regulated and supervised by the Central Bank. In addition to the central bank, the banking
sector in Kuwait is mainly composed of eight conventional banks (six commercial and two
specialized banks) and an Islamic bank. The structure of the banking sector is fairly
concentrated. The National Bank of Kuwait (NBK) is more than twice the size of the next
largest, the Gulf Bank (GB), in terms of assets and deposits. The National Bank of Kuwait is
the largest bank and one that also maintains an international network. With an amendment to
the Banking Law of 1968, the National Assembly allowed foreign banks to establish
operations in Kuwait.

National Bank of Kuwait and Gulf Bank own around 50% of the assets of conventional banks
and dispense around the same proportion of total banking credit. These two banks have had
the best records in terms of profitability and financial positions. Figure 1 shows the
comparison between the sizes of these banks. The two specialized government-owned banks
provide medium and long-term financing. The Industrial Bank of Kuwait offers financing for
industrial and agriculture-related projects. The Kuwait Real Estate Bank offers financing of
residential and commercial property developments.

III. METHODOLOGY AND DATA

Three hypotheses are tested in this study. The first hypothesis is measuring the relationship
between operating profit and asset-liability components. It is generally hypothesized in
finance that the higher the level of risk the higher the expected return, due to this notion, the
second hypothesis tries to measures the relationship between risk and return. The emphasis
here is on measuring which type of risk generates higher returns (i.e. is it credit risk, liquidity
risk or capital risk?) The third hypothesis is to test whether there are any differences among
the size of banks in their asset-liability management.

The Statistical Cost Accounting (SCA) method has been used to test these
hypotheses. SCA method assumes that the rate of return on earning assets is
positive and varies across assets, whereas the rate of cost on liabilities is
negative and varies across liabilities. According to Kosmidou et al (2004), this
method was tested in American, Indian, Greek and Italian banks (Hester, 1964;
Hester and Zoellner, 1966; Hester and Pierce, 1975; Kwast and Rose, 1982;
Vasiliou, 1996; Calcagnini and Hester, 1997). Our study is a partial replication of
the work done by Kosmidou et al. (2004) where they studied 36 domestic and 44
foreign banks operating in the UK over the period 1996-2002 to examine the
asset-liability relationship. Komidou et al. (2004) concluded that assets are
positively and liabilities are negatively related to profits. This result was
consistent for local and foreign banks.

In our study, all eight banks listed in the Kuwait Stock Market were examined over a period
of 18 years from 1980 to 1997. The list of the banks is given in Table 1. The reason for this
time period is to have a reasonable data covering the period before and after the Iraq invasion
and also because longer time periods might not give a clear picture. The time series is divided
in two periods: 1980 to 1989 the ten years before the invasion (Gulf War) and 1991 to 1997,
which covers the period after the invasion. Data for 1990 is not available, so it is excluded
from the study. Year 1991, which is the first year after the invasion, is sometimes dropped
from some analyses because data in this year is extraordinary for most of the banks. With
these adjustments to the data, the total number of observations for the study ended up to 122,
i.e. approximately 17 observations per bank. Data has been collected from the Financial
Operating Report published by the research unit of the Institute of Banking Studies in Kuwait
together with the financial reports for each bank. The listing of banks in Table 1 is based on
the size of total assets. The first six banks in Table I are the commercial banks while the other
two, the Industrial Bank of Kuwait and Kuwait Real Estate are specialized banks. These
specialized banks are the smallest in terms of their assets compared to the commercial banks.
This is clearly shown in Figure 1.

[FIGURE 1 OMITTED]

The Statistical Cost Accounting method applied in this study relates differences in
profitability to differences in assets and liabilities. Thus, the model for a bank in year t used
in this study is described as follows:

[P.sub.lt] = [a.sub.0] [[summation].sub.b1i][A.sub.ilt] [[summation].sub.b2j][L.sub.jlt]

[e.sub.jt] (1)

Where

P denotes the operating profit of a bank

[A.sub.i] is the ith asset, i= 1, 2, ... m

[L.sub.j] is the jth liabilities, j = 1, 2, ... n

l denotes the number of banks, l = 1, 2, ... k

t is the time period, t = 1, 2, ... T

b1i denotes the marginal rates of return and indicates the changes in the bank's profit by
replacing one unit of cash with one unit of the ith asset and is expected to be positive.

b2j denotes the marginal costs of liabilities and indicates the changes in the bank's profit by
adding one unit of cash and one unit of jth liability and is expected to be negative.

[a.sub.0] is a constant term

[e.sub.jt] is a stochastic term

To eliminate the size bias, all variables of model (1) are divided by the bank's total assets
([A.sub.i]) and model (2) is developed. Since all variables are divided by total assets, i.e.
dependent and independent variables are converted to ratios, the new ratios are computed
from the liability figures and included in the model to measure the level of risk. These risk
measures are: liquidity, capital, and credit risk which are defined in Table 2.

In model (2), the dependent variable is changed to ROA and the liability figures changed to
risk ratios. Fraser and Fraser (1991) argued that ROA and ROE are the best measures of
profitability. Murphy et al. (1996) argued that in cross-sectional studies, the use of ROA is a
more conservative measure of performance than ROE.

[P.sub.lt] / [A.sub.lt] = [a.sub.0] / [A.sub.lt] [summation] ([sub.b1i][A.sub.ilt]) / [A.sub.lt]

[summation] ([sub.b2j][L.sub.jlt]) / [A.sub.lt] [sub.b3q][R.sub.qlt] [u.sub.lt] (2)

Where

[u.sub.lt] is [e.sub.lt] / [A.sub.lt] is a stochastic term

[A.sub.i] is the ith asset, i = 1, 2, ... m

[L.sub.j] is the jth liabilities, j = 1, 2, ... n

l denotes the number of banks, l = 1,2 ... k

t is the time period, t = 1, 2, ... T

[R.sub.qlt] is different types of risks, (liquidity, capital, credit)

b1i denotes the marginal rates of return and indicates the changes in the bank's profit by
replacing one unit of cash with one unit of the ith asset and is expected to be positive.

b2j denotes the marginal costs of liabilities and indicates the changes in the bank's profit by
adding one unit of cash and one unit of jth liability and is expected to be negative.

[a.sub.0] is a constant term

[e.sub.jt] is a stochastic term

The difference between model (1) and model (2) is that the first model deals with absolute
figures in Kuwaiti Dinars while the second one deals with ratios. Stepwise regression is used
for both models to test the null hypothesis that there is no relationship between profits
generated by a bank and its assets or liabilities. T-test is used for all models at a significant
level of 1%. Durban-Watson (DW) statistic is also used to test for autocorrelation. Finally,
residual analysis is also conducted to test for heteroscedasticity in the variables. The variables
used in these two models are listed in Table 2.

To test for the size differences, the sample has been divided to include two sub-samples:
small and large banks and two models are developed for each size. Additionally, the sample
has been split into two groups, according to their performance measured by their ROA. The
first group includes the most profitable banks and the second, the less profitable ones. The
cut-off point for the split is based on the annual industry's average ROA. ROA with more
than the industry in the same year is considered as large profit firms and less than the industry
is the small profit firms. This is consistent with the study done by Kosmidou et al. (2004). To
separate between the two groups in one model, dummy variables are also used for the size.
Additionally, a dummy variable (I) is used to see whether there is any difference between
profit generation through assets-liabilities management before and after the invasion.
IV. EMPIRICAL RESULTS

All variables explained in model (1) were included in the stepwise regression and the
statistical significant variables in terms of t-values are summarized in table 3. All variables,
including the two dummy variables for the size and invasion are statistically significant at 1%
level. All assets have shown a positive relation in generating the profit for the year with the
exception of "Fixed and other Assets" which is found to be negative. The reason could be that
this variable which is mainly land, building and investment in different small types of assets,
is not only incapable of generating profit but also reduces the opportunity for investment in
profitable investments. The more money is invested in this kind of assets, the lesser the
opportunity for giving loans and investment on longer term assets. On the other hand, the t-
value for proposed dividend provides statistical significant results indicating that the more the
dividend, the higher the operating profit generated by the bank. It could be that investors are
short-sighted and attracted to banks which provide higher dividends. In other words,
dividends might be a positive signal in the market attracting funds from depositors and clients
for taking loans.

Looking at the dummy variables in explaining the profit, the size dummy variable shows that
there is a significant difference between small and large profit banks, (t-value = 4.096).
Similarly, the dummy variable for the invasion shows a significant difference between the
Table 4 summarizes the regression statistics for model (2) including all measures of risk with
ROA as the dependent variable. The results are consistent with model (1) with some
additional explanation. Individual liability variables are changed to different types of risks:
Liquidity risk, Capital risk and Credit risk. All these risk measures show statistical significant
t-values at 1% level of significance, indicating the positive relationship between risk and
return. The result is significant for the shareholders because they are interested to see the
status of the bank and to measure whether the bank is able to provide a reasonable ROA.
Creditors and depositors are also interested in these performances to observe the ability of
these banks for repaying debts and meeting the withdrawal requirements. The results
achieved could help management to be prepared for avoiding the bank failure. two periods,
before and after the invasion (t-value = 3.080).

Table 4 summarizes the regression statistics for model (2) including all measures of risk with
ROA as the dependent variable. The results are consistent with model (1) with some
additional explanation. Individual liability variables are changed to different types of risks:
Liquidity risk, Capital risk and Credit risk. All these risk measures show statistical significant
t-values at 1% level of significance, indicating the positive relationship between risk and
return. The result is significant for the shareholders because they are interested to see the
status of the bank and to measure whether the bank is able to provide a reasonable ROA.
Creditors and depositors are also interested in these performances to observe the ability of
these banks for repaying debts and meeting the withdrawal requirements. The results
achieved could help management to be prepared for avoiding the bank failure.

Considering the size factors, two models are developed for generally high-profit banks
compared with low-profit banks, once for model (1) and next for model (2) as reported and
summarized in Tables 5 (a) and 5 (b). These tables clearly show that there is a significant
difference between assets-liabilities management among high and low-profit banks'. High-
profit banks generally generate profits positively with assets and negatively with liabilities.
The [R.sup.2] is very high 0.95 indicating that 95% of the variation in the profit is explained
correctly by the assets and liabilities. Low-profit banks produced unusual models with
negative relation between loans and profits. This could be the case in Kuwait where they
could charge low interest for loans. Alternatively, it could be that the sample is small and
other variables are missing in the model since [R.sup.2] is very low (0.27). Table 5 (b) shows
that liquidity and capital risk are the two significant key points for determining profits for
small profit banks, both variables having significantly high t-values at 1%. Additionally,
deposits and investments also contribute positively to the profits generated by the bank.

Categorizing the banks as small and large in terms of their assets, or as commercial and
specialized their portfolios of assets-liabilities also differ. Two models are developed for each
size/type and the summary for the regression model is reported in Table 6. In all the two sub-
samples the relationship between risk and return is shown to be positive. But the level of risk
varies according to size of the bank. Liquidity risk, credit risk, capital risk are all highly
significant for small and specialized banks, while only liquidity risk is significant for large
banks. Additionally, "Deposits and investment in banks" has very significant effect on return
on assets for large firms.

Government bonds are found to be either insignificant or negatively related to profit for
small-profit banks. This strange relationship is because the government has swapped the un-
functioning loans into bonds--as a result, profitability has been negatively affected because
debt bonds could not be traded or discounted. In addition, the debt settlement problem has
increased the banks' risk aversion to large lending operations and hence might have deprived
them from profitable opportunities.

Kosmidou et al. (2004) investigated the performance of large and small banks in the UK, they
concluded that small banks exhibit higher overall performance compared to large ones. The
finding was also similar to the study done by Vasilion (1996) for Greek banks where it was
found that annual rates of return on fixed assets are higher for the high-operating profit group.
The results for Kuwaiti banks do not provide evidence that small banks generate greater
profit, but interestingly it showed that the behavior of assets-liabilities management differ for
small compared to large firms in generating profits. Low profit firms have more emphasis on
capital risk, liquidity risk, and deposits and investments. On the other hand, large profit banks
have more emphasis on taking credit and capital risk and reducing fixed assets in order to
generate profit. This final finding contradicts the results reported by Kosmidou et al (2004)
where they found a positive relation between fixed assets and profits.

Looking at the effect of the Iraq Invasion, Table 7 reports the summary results. Before the
invasion, three variables were found to be highly significant at the 0.001% level. Dividends
and total deposits both have a positive effect in generating profits while loans were found to
be negatively affecting profits. This result is also consistent with the small-profit bank which
was reported in Table 6. The result after the Invasion looks the opposite. Loans are positively
related to the profit with t-value (8.488) and significant at 0.001% while "Fixed and Other
Assets" is negatively related--which is consistent with model (1).

V. CONCLUSION
In this study all commercial and specialized banks listed in Kuwait are examined in order to
develop models for asset-liability managements in relation to profit generation. The results
provide evidence that generally assets, mainly loans, positively contribute to the profit but
liabilities, mainly deposits, negatively contribute to the profit. The significance of individual
assets differs: loans ate highly significant and followed by deposits and investments, while
the Fixed and Other Assets where found to be negatively related to profit.

The strange results of the two different periods of the study before and after the invasion
describe the unusual case of Kuwait. Due to the Stock Market crash in 1980s and the invasion
of Kuwait in 1990, banks were left with large non-performing loans. These loans were
swapped to government bonds for long term maturities by the government of Kuwait.

Another salient feature of Kuwaiti banks is the mixed nature of their ownership. Except for
NBK, which is almost entirely owned by the private sector, the government is a shareholder
in the rest of the banks. The joint ownership of banks and the reputation gained by the
government as "a bailer of last resort", may have contributed to the bank's propensity for
imprudent behavior.

The results of this paper may help banks to determine the factors which might create more
profit and differentiate high and low-profit banks. Furthermore, this paper examines if there
are any differences in banks operating on a small scale of large scale. In general, a statistical
cost accounting analysis could be of particular interest to bank management, as the managers
can employ this analysis to identify the relative position of their banks in relation to their
main competitors. This will enable them to identify their competitive advantages and
disadvantage and to change their policies towards asset and liability management. Finally, a
number of additional ratios could be added to the models developed in order to get a better
explanation of the profit. Moreover, information from the stock market could be added to the
model to see the effect of the market on the profit. Finally, a comparison study could be made
between commercial and Islamic banks.

APPENDIX I
Definition of the terms according to the Institute of Banking
Studies-Kuwait

Terms Definitions
Assets Assets are economic resources owned
by the
bank. The assets are further
classified as
liquid assets, loans, investments,
fixed
assets, etc.

Liquid Assets Cash in hand and readily available

bank
balances such as demand deposits or
current
account balance, other short term
deposits,
treasury bills, and other assets that
can be
quickly converted into cash.

Loans and advances All types of loans, advances,

discounts and
overdrafts provided to others by the
bank.

Investments excluding All types of investments in shares,

bonds,
debt purchase bonds investments in subsidiaries and
affiliates,
and other investments which are not
considered as of short term nature.

Fixed and other assets All tangible long term assets like
land,
buildings, furniture, and equipment
are
included in the fixed assets. Other
assets
include all unspecified assets.

Liabilities Amounts owned by the bank to others,

other
than the shareholders. They also
represent
major sources of funds used by the
bank.
The total liabilities consist of
deposit
liabilities, debts/loans/borrowings,
and
other liabilities.
Deposit liabilities Consist of deposits obtained by the
bank from
individual customers, business firms,
other
banks, other organizations and other
agencies
and certificates of deposits.

Other liabilities Any liability not classified as

deposits or
borrowings. It also includes
provisions.

Total equity All paid up share capital including

share
capital raised by right-issues and
bonus
share issues (share capital), and all
types
of statutory/legal/special/general
reserves
created out of the profits of the
bank, and
any undistributed or unallocated
profits
retained in the business (Reserves
and
retained earnings).

REFERENCES

Kosmidou K., and Pasiouras F., Floropoulos J. (2004), "Linking Profits to Asset-liability
Management of Domestic and Foreign Banks in the UK", Applied Financial Economics, Vol.
14, 1319-1324.

--and Zopounidis, C. (2004), "Combining Goal Programming Model With

Simulation Analysis For Bank Asset Liability Management Information",
INFOR, Aug Vol. 42, No. 3.
Calcagnini, G. and Hester, D. D. (1997), "Cambiamento Istituzionale e Redditivita Delle
Banche in Italia," Rivista di Politica Economica, January, 3-43.

Fraser, L. M., and Fraser, D. R. (1991), "Evaluating Commercial Banks Performance, A

Guide to Firm Analysis", Probus Professional Publication.

Gunther, J. W. (1989), "Texas Banking conditions: Managerial Versus Economic

Conditions", Federal Reserve Bank of Dallas, October.

Gup, B. E., and Brooks, R. (1993), "Interest Rate Risk Management", Irwin Professional
Publishing, Burr Ridge.

Hester, D. D. and Pierce, J. L. (1975), "Bank Management and Portfolio Behaviour", Yale
University. Press, New Haven, CT.

--(1964), "Indian Banks: Their Portfolios, Profits and Policy", Bombay University Press,
Bombay India.

--and Zoellner, J. F. (1966), "The Relation between Bank Portfolios and Earnings: An
Economertirc Anlaysis", Review of Economics and Statistics, XLVIII, 372-86.

Kwast, M. L and Rose, J. T. (1982), "Pricing, Operating, Efficiency, and Profitability among
Large Commercial Banks", Journal of Banking and Finance, Vol. 6, 233-54.

Vasiliou, D. (1996), "Linking Profits to Greek Bank Production Management", International

Journal of Production Economics, Vol. 43, 67-73.

BATOOL K. ASIRI

Department of Economics and Finance

University of Bahrain, Bahrain

Table 1
Listed banks in the Kuwait Stock Market

Total Assets
(in million
KD)

No. Name Established 1980 1997

1. The National Bank of Kuwait 1952 1374 4118

(NBK)
2. The Gulf Bank (GBK) 1960 1168 1739
3. Al-Ahli Bank of Kuwait (ABK) 1967 1021 1255
4. Commercial Bank of Kuwait (CBK) 1960 1006 1288
5. The Burgan Bank (BB) 1976 409 1145
6. Bank of Kuwait and the Middle 1971 550 919
 East (BKME)
7. Kuwait Real Estate Bank (KREB) 1973 310 554
8. The Industrial Bank of Kuwait 1973 434 383
(IBK)

Table 2
Independent variables

Variable Description (2)

A1 Liquid assets: Cash short term deposit treasury bills

guaranteed funds deposit certificate
A2 Deposits in banks and Investments in quoted and unquoted
securities
A3 Loans and borrowings
A4 Government Bonds
A5 Fixed assets and other assets
L1 Total deposits
L2 Other liabilities
L3 Proposed dividends
CapR Capital Risk = Equity / Total Assets
LigR Liquidity Risk = Liquid (Short-term) assets / Deposits
CrdR Credit Risk = Loans / Total Assets
LM Leverage Multiplier = Total Assets / Equity
D1 Dummy variable: 0 = low and 1 = high profit
D2 Dummy variable: 0 = before invasion and 1 = after invasion

Table 3
Regression results for Model (1), Dependent Variable: Operating income

Variables Coefficients Standard error

(Constant) -10.547 2.744

Liquid Assets 0.054 0.011
Dividends 0.571 0.128
Fixed and Other Assets -0.101 0.033
Deposits & Investment 0.030 0.008
Total Deposits -0.030 0.007
Loans and Discount 0.043 0.010
D1: Size: 0 = small, 1 = large 8.725 2.130
D2: Invasion: 0 = before, 1 = after 12.999 4.216

Adj [R.sup.2] = 0.625 DW = 1.906 df = 122

Variables t-value Sig-level

(Constant) -3.843 0.000

Liquid Assets 5.004 0.000
Dividends 4.445 0.000
Fixed and Other Assets -3.099 0.002
Deposits & Investment 3.625 0.000
Total Deposits -4.364 0.000
Loans and Discount 4.420 0.000
D1: Size: 0 = small, 1 = large 4.096 0.000
D2: Invasion: 0 = before, 1 = after 3.083 0.003

Adj [R.sup.2] = 0.625 F-sig = 0.001

Table 4
Regression Results for Model (2), Dependent Variable: ROA

Variables Coefficients Standard error

(Constant) -2.817 0.538

Liquidity Risk 0.051 0.011
Capital Risk 0.103 0.024
Credit Risk 0.020 0.007
Deposit & Investment/Total Assets 0.021 0.008
Proposed Dividends 0.036 0.009
Fixed & Other Assets/Total Assets -0.005 0.002

Adj [R.sup.2] = 0.344 DW = 1.927

Variables t-value Sig-level

(Constant) -5.231 0.000

Liquidity Risk 4.712 0.000
Capital Risk 4.228 0.000
Credit Risk 2.844 0.005
Deposit & Investment/Total Assets 2.697 0.008
Proposed Dividends 4.017 0.000
Fixed & Other Assets/Total Assets -2.185 0.031

Adj [R.sup.2] = 0.344 df = 123

Table 5 (a)
Regression results for Model (1), High v. Low-profit banks
Dependent Variable: Operating profit

Standard
Models Variables Coefficients error

(1) High Profit (Constant) -8.153 8.320

Banks Liquid Assets 0.052 0.017
Loans and Discount 0.031 0.011
Fixed and Other Assets -0.116 0.051
Total deposits -0.025 0.012
Dividends 1.112 0.340

Adj [R.sup.2] = 0.952 df = 53

(2) Low Profit (Constant) 3.052 1.375

Banks Loans and Discount -0.024 0.012
Government Bonds -0.026 0.011
Shareholder's equity 0.054 0.020

Adi [R.sup.2] = 0.273 df = 68

Models Variables t-value Sig-level

(1) High Profit (Constant) -0.980 0.332

Banks Liquid Assets 3.055 0.004
Loans and Discount 2.776 0.008
Fixed and Other Assets -2.262 0.028
Total deposits -2.021 0.049
Dividends 3.272 0.002

Adj [R.sup.2] = 0.952

(2) Low Profit (Constant) 2.219 0.031
Banks Loans and Discount -1.947 0.057
Government Bonds -2.289 0.026
Shareholder's equity 2.713 0.009

Adi [R.sup.2] = 0.273

Table 5 (b)
Regression results for Model (2), High v. Low-profit Banks
Dependent Variable: ROA

Standard
Models Variables Coefficients error

(1) High Profit (Constant) -1.073 0.610

Banks Fixed & Other Assets/
Total Assets -0.019 0.005
CreditRisk 0.031 0.008
CapitalRisk 0.086 0.038

Adj [R.sup.2] = 0.496 df = 53

(2) Low Profit (Constant) -1.582 0.424

Banks CapitalRisk 0.086 0.021
Liquidity Risk 0.041 0.009
Deposits & Investment/
Total assets 0.029 0.009
Dividends 0.016 0.007

Adj [R.sup.2] = 0.273 df = 68

Models Variables t-value Sig-level

(1) High Profit (Constant) -1.760 0.083

Banks Fixed & Other Assets/
Total Assets -3.976 0.000
CreditRisk 3.877 0.000
CapitalRisk 2.257 0.027

Adj [R.sup.2] = 0.496

(2) Low Profit (Constant) -3.732 0.000

Banks CapitalRisk 4.149 0.000
Liquidity Risk 4.375 0.000
Deposits & Investment/
Total assets 3.312 0.002
Dividends 2.292 0.026

Adj [R.sup.2] = 0.273

Table 6
Regression results for Model (2), Commercial (Large) v. Specialized
banks (Small) Dependent Variable: ROA

Standard
Models Variables Coefficients error

(1) Commercial (Constant) -1.671 0.494

banks (Large Liquidity Risk 0.055 0.016
Total Assets) Deposit & Inv/Total Assets 0.029 0.009
 Dividends 0.029 0.010

Adj [R.sup.2] = 0.207 df = 89

(2) Specialized (Constant) -3.660 0.824

banks (Small Liquidity Risk 0.078 0.014
Total Assets) Credit Risk 0.035 0.010
Capital Risk 0.075 0.032
Dividends 0.391 0.145

Adj [R.sup.2] = 0.637 df = 32

Models Variables t-value Sig-level

(1) Commercial (Constant) -3.380 0.001

banks (Large Liquidity Risk 3.520 0.001
Total Assets) Deposit & Inv/Total Assets 3.329 0.001
Dividends 3.022 0.003

Adj [R.sup.2] = 0.207

(2) Specialized (Constant) 4.900 0.000

banks (Small Liquidity Risk 5.636 0.000
Total Assets) Credit Risk 3.710 0.000
Capital Risk 2.375 0.002
Dividends 2.700 0.000

Adj [R.sup.2] = 0.637

Table 7
Regression results for Model (1), Before and After the Invasion
Dependent Variable: Operating profit

Standard
Models Variables Coefficients error

(1) Before invasion (Constant) 1.297 0.516

Dividends 1.002 0.118
Total deposits 0.012 0.002
Loans and Discount -0.016 0.003

Adj [R.sup.2] = 0.908 df = 77

(2) After invasion (Constant) 6.060 4.253

Loans and Discount 0.073 0.009
Fixed and Other Assets -0.442 0.096

Adj [R.sup.2] = 0.614 df = 44

Models Variables t-value Sig-level

(1) Before invasion (Constant) 2.511 0.014

Dividends 8.464 0.000
Total deposits 7.127 0.000
Loans and Discount -5.661 0.000

Adj [R.sup.2] = 0.908

(2) After invasion (Constant) 1.425 0.162

Loans and Discount 8.488 0.000
Fixed and Other Assets -4.620 0.000
 Adj [R.sup.2] = 0.614

COPYRIGHT 2007 Indian Journal of Economics and Business

CONCLUSIONS

Emerging issues in the Indian context

With the onset of liberalization, Indian banks are now more exposed to uncertainty and to
global competition. This makes it imperative to have proper asset-liability management
systems in place. The following points bring out the reasons as to why asset-liability
management is necessary in the Indian context: . In the context of a bank, asset-liability
management refers to the process of managing the net interest margin (NIM) within a given
level of risk.

NIM = Net Interest Income/Average Earning Assets = NII/AEA

Since NIl equals interest income minus interest expenses, Sinkey (1992) suggests that NIM
can be viewed as the spread on earning assets and uses the term spread management. As the
basic objective of banks is to maximize income while reducing their exposure to risk,
efficient management of net interest margin becomes essential. . Several banks have
inadequate and inefficient management systems that have to be altered so as to ensure that the
banks are sufficiently liquid. . Indian banks are now more exposed to the vagaries of the
international markets, than ever before because of the removal of restrictions, especially with
respect to forex transactions. Asset-liability management becomes essential as it enables the
bank to maintain its exposure to foreign currency fluctuations given the level of risk it can
handle. . An increasing proportion of investments by banks is being recorded on a marked-to-
market basis and as such large portion of the investment portfolio is exposed to market risks.
Countering the adverse impact of these changes is possible only through efficient asset-
liability management techniques. . As the focus on net interest margin has increased over the
years, there is an increasing possibility that the risk arising out of exposure to interest rate
volatility will be built into the capital adequacy norms specified by the regulatory authorities.
This, in turn will require efficient asset-liability management practices.

SUGGESTIONS
It is important to note that the conglomerate approach to financial institutions, which is
increasingly becoming popular in the developed markets, could also get replicated in Indian
situations. This implies that the distinction between commercial banks and term lending
institutions could become blurred. It is also possible that the same institution involves itself in
short-term and long-term lending-borrowing activities, as well as other activities like mutual
funds, insurance and pension funds.

In such a situation, the strategy for asset-liability management becomes more challenging
because one has to adopt a modular approach in terms of meeting asset liability management
requirements of different divisions and product lines. But it also provides opportunities for
diversification across activities that could facilitate risk management on an enhanced footing.
In other words, in the Indian context, the challenge could arise from say the merger of SBI,
IDBI, and LIC.

Such a scenario need not be considered extremely hypothetical because combined and
stronger balance sheets provide much greater access to global funds. It also enhances the
capability of institutions to significantly alter their risk profiles at short notice because of the
flexibility afforded by the characteristics of products of different divisions. This also requires
significant managerial competence in order to have a conglomerate view of such
organizations and prepare it for the challenges of the coming decade.

As long as the artificial barriers between different financial institutions exist, asset liability
management is narrowly focussed and many a time not in a position to achieve the desired
objectives. This is because of the fact that the institutional arrangements are mainly due to
historical reasons of convenience and a perceived static picture of the operating world. The
integration of different financial markets, instruments and institutions provide greater
opportunities for emerging markets like India to aim for higher return in the context of
minimizing risk.

Hence, it maybe appropriate to think in terms of reorienting our institutional structures

(removing the distinctions between commercial banks, non-banking financial companies, and
term lending institutions to start with) and having a conglomerate regulatory framework for
monitoring capital adequacy, liquidity. solvency, marketability, etc. This will go a long way
in ironing out the mismatches between the assets and the liabilities, rather than narrowly
focussed asset-liability management techniques for individual banks

REFERENCES

Fabozzi, FJ., & Konishi, A. (1995). Asset-liability management. New Delhi: S

Chand & Co.

Harrington, R. (1987). Asset and liability management by banks. Paris: OECD.

Jain, J.L. (1996). Strategic planning for asset liability management. The Journal
of the Indian Institute of Bankers, 67(4).

Kannan, K (1996). Relevance and importance of asset-liability management in

banks.
The Journal of the Indian Institute of Bankers, 67(4).

Saunders, A. (1997). Financial institutions management (2nd ed). Chicago: Irwin.

Shah, S. (1998). Indian legal hierarchy. Mumbai: Sudhir Shah Associates

(website).

Sinkey, J.F. (1992). Commercial bank financial management(4th ed). New York:
Maxwell Macmillan International Edition.

Vaidyanathan, R (1995). Debt market in India: Constraints and prospects.

Bangalore: Center for Capital Markets Education and Research, Indian Institute of
Management-Bangalore.

The World Bank (1995). The emerging Asian bond market: India. Prepared by ISec
Mumbai.

Vaidyanathan, R (1995). Debt market in India: Constraints and prospects.

Bangalore: Center for Capital Markets Education and Research, Indian Institute of
Management-Bangalore.

Bank Asset and Liability Management: Strategy, Trading, Analysis - Moorad Choudhry
WEBSITES
www.google.com
www.scribd.com
www.bussinesstoday.com
www.timesofindia.com

NEWSPAPERS/MAGAZINES
The Financial Express
Business Today

Asset and Liability Management Magazines

o Bank Asset/Liability Management - Sheshunoff Information Services
Asset and Liability Management Journals
o Journal of Asset Management - Palgrave Macmillan
Asset and Liability Management Internet
o ALM Professional - www.almprofessional.com
Dos and Don’tss

Do
• Talk to one of the many consultancy firms that specialize in ALM, and that can
advise on establishing an ALM committee and improving its performance.
• Ensure those appointed to the ALM committee have the necessary knowledge and
experience to perform their tasks.
• Constantly monitor the performance of your committee.

Don’t
• Don’t seek to cut costs in terms of investing in management tools and personnel.
• Don’t forget that risks are constantly changing and developing. Make sure your
ALM committee has the skills to deal with the latest developments .