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WEST BENGAL UNIVERSITY OF

TECHNOLOGY
SUMMER PROJECT
REPORT
ASSET LIABILITY
MANAGEMENT
AT
UCO BANK
BY
SUBARNA GUPTA
WBUT ROLL NO.:
08136009013 WBUT REGN
NO.: 081360710098 ARMY
INSTITUTE OF MANAGEMENT

KOLKAT
A

ASSET LIABILITY MANAGEMENT


2009

ASSET LIABILITY MANAGEMENT

SUBARNA
GUPTA

ASSET LIABILITY
MANAGEMENT

2009

CONTENTS
Serial

Topic

Page No

I.

Guidance-cum-completion certificate

II.

Acknowledgement

III.
IV.

Executive Summary
Corporate Profile

9
11

V.

Purpose and scope of study

14

VI.

Methodology

14

VII.

Project Details

15

1.
1.1.
1.2.
2.
2.1.
3.

Introduction
Definition of risk
Relation between risk and return
Risk in context of banking sector
Types of Risks
Risk Management

16
16
16
17
17
21

3.1.

21

3.2.

Key Factors in the evolution of financial institution


risk management practice
Steps involved in risk management

3.3.

Techniques of risk management

22

Asset Liability Management

23

4.1.

Definition

23

4.2.

Importance of ALM

23

4.3.

Significance of ALM

24

4.4.

Parameters for stabilizing ALM

24

5.

ALM Organizational Structure

25

5.1.

Composition of ALCO

25

5.2.
5.3.
5.4.
5.5.
6.
7.
7.1.

The Mid Office


The Dealing Room
The Back Office
Functions of ALM: Roles & Responsibilities
ALM Process
Management of Liquidity Risk
Adequacy of liquidity position of a bank

25
26
26
27
28
35
37

7.2.

Sources of liquidity risk

37

4.

21

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2009

7.3.

Types of liquidity risk

37

7.4.

Measuring and managing market risk

38

7.5.

Case study on dynamic liquidity

41

7.6.

Structural liquidity statement

43

Management of Interest Rate Risk

44

8.1.

Types of Interest rate risk

47

8.2.

Effects of Interest rate risk

51

8.3.

Interest rate risk management techniques

51

8.4.

Sound interest rate risk management principles

52

Management of Exchange Rate Risk

53
54
55

9.3.

Types of exchange risk


Tools and techniques of managing foreign exchange
risk
Steps in forex risk management

9.4.

Strategies for foreign exchange management

58

10.

Fund Transfer Pricing

59

11.

Value at Risk (VaR) & Duration based ALM

61

11.1.

The idea behind VaR

61

11.2.

Methods of calculating VaR

61

11.3.

Uses of VaR

62

Importance of IT and software in ALM

63

A Typical ALM System

64

Collection and Analysis of Data

68

13.1.

ALM: A Banks Case Study

69

13.2.

Data Analysis

69

Findings and recommendations

71

14.1.

Liquidity under crisis scenario

71

14.2.

Estimation of liquidity under market crisis scenario

72

15.

Conclusion

73

16.
17.
18.
19.
20.

Constraints and limitations


Scope of further study
Annexure I
Annexure II
Bibliography

74
74
75
80
83

8.

9
9.1.
9.2.

12.
12.1.
13.

14.

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LIST OF TABLES
Serial

Topic

Page no.

Organizational structure (UCO Bank)

13

Some probable risk scenario

20

ALM History

23

Composition of Liquid Fund

36

Dynamic liquidity structure of ABC Bank

42

Expected balance sheet of hypothetical bank

45

1% increase in short term rates: Expected balance sheet of


hypothetical bank

46

1% decrease in short term rates: Expected balance sheet of


hypothetical bank

46

Proportionate doubling in size: Expected balance sheet of


hypothetical bank

46

10

Increase in RSAs and decrease in RSLs: Expected balance


sheet of hypothetical bank

47

11

Statement showing impact of changing interest rates on


repricing assets and liabilities

48

12

Relation between interest rate changes and their impact on


NII

49

13

Interest sensitive gap position of 1-30 days bucket of XYZ


bank and Net impact on NII under changed scenario

49

14

Table showing yield curve risk involved as the spread


between two maturities of Treasury Bills is narrowed

50

15

Fund Management Profit Centre: The liability, credit and


mismatch spreads of a bank

60

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LIST OF FIGURES

Serial

Topic

Page no.

Graph showing risk return trade-off

16

Flow of information towards decision making in ALM

29

Impact of hedging on expected cash flows of the firm

54

Conceptual comparison on differences among Operating,


Transaction and Translation foreign exchange exposure

55

Framework of Foreign Exchange Risk Management

57

SUBARNA
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ASSET LIABILITY MANAGEMENT


2009

CERTIFICATE
This is to certify that Ms SUBARNA GUPTA, WBUT
Registration. No 081360710098 of ARMY INSTITUTE OF
MANAGEMENT,
undertaken

WBUT

the

Roll

project

No
titled

08136009013
ASSET

has

LIABILITY

MANAGEMENT under our guidance from 8th of June 09


to 21st of July 09 at UCO BANK, Head Office and has
completed the said project successfully.

External Guides Full


Signature

ORGANIZATIONS SEAL

Designation

SUBARNA
GUPTA

ASSET LIABILITY MANAGEMENT


2009

ACKNOWLEDGEMENT
It is with immense pride and satisfaction that I present this project titled
ASSET LIABILITY MANAGEMENT studied and developed at UCO BANK,
Head Office, and Kolkata.
I would also like to thank Mr. S. Mishra, Assistant General Manager, HR
Department for allowing me to pursue my Summer Internship Project in
UCO Bank.
UCO Bank deserves a very special mention for providing generous support
in the preparation of this report. I accord my humble thanks to Mr. D. P
Chatterjee, General Manager, Inspection & Risk Management and Late Mr.
R.K. Jain, Assistant General Manager, Risk Management for their
unforgettable help, kind encouragement and providing me the idea to
select the topic.
I feel elevated in expressing my gratitude and indebtness to Mr. Gopala
Krishnan, Chief Officer of Risk Department (Industry Guide) for his sincere
guidance, sustained interest and incessant encouragement throughout the
course of preparation.
I would like to sincerely thank Mr. S. Senthil Kumaram and Mr. Pranab
Biswas for their kind help in the initial days of my internship right from
introducing the topic to guiding me and making me aware of all possible
guidelines which are used in Asset Liability Management and their
encouragement.
I shall be failing in my duty if I do not thank Professor Kousik Guhathakurta
(College Guide) of my college, Army Institute of Management, Kolkata for
his direct and indirect helps during preparation of my report.
It was a very fruitful learning experience and involved interaction with
various people both in and out of the bank. I would also like to thank the
staff members of Risk Management Department for providing me the
valuable thoughts and inputs in order to make my study affluent.
I take this opportunity to declare my utmost sincere gratitude to my
affectionate parents for their blessings and encouragement for the
successful completion of this project.
Lastly there are many well wishers, friends and dear ones who directly and
indirectly rendered with valuable help to complete this professional
endeavor.
I have deep sense of reverence for all of them. The greatest of this credit
goes to the blessing bestowed upon me by the Lord without whose
yearning; I could not have even moved a step forward.

SUBARNA
GUPTA

ASSET LIABILITY MANAGEMENT


2009

ExEcutive Summary
As Alan Greenspan, Chairman of the US Federal Reserve observed, risk taking is a
necessary condition for wealth creation. Risk arises as a negative deviation between
what happens and what was expected to happen. Banks are no exception to this
phenomenon. As a result managements have to create efficient systems to identify
measure and control the risk and ALM provides the overall picture of the asset liability
profile of an institution. The objective of ALM is to maximize returns through efficient fund
allocation and maturity mismatch management given an acceptable risk structure. ALM
is a multidimensional process, requiring simultaneous interactions among different
dimensions.
Increased globalization and large volume of cross border financial transactions pose a
significant challenge in effectively managing the asset liability of any institution,
particularly, commercial bank. The post Lehman scenario where credit risk culminated
into liquidity risk provided the required insight for all banks across the world to take a
relook at reassessing their asset liability profile. Under these circumstances, managing
asset and liability to achieve the desired corporate objective with manageable and
known risk is gathering currency. This particular scenario provided a necessary impetus
for undertaking this project.
UCO bank, one of the oldest and major commercial banks in India, introduced the ALM
process under the RBI guidelines. This project involves detailed study of the ALM- its
various aspects, the process, how it is practiced in the bank. This includes management
of liquidity risk, foreign exchange rate risk and interest rate risk- their respective
techniques and processes.
The project begins with introducing risk and risk management which includes the factors
behind evolution of financial institution risk management practice, the steps involved in
risk management (i.e. identification, measurement and mitigation of risk) and the
techniques of risk management.
Asset liability management arises from the inherent nature of term intermediation of
maturing assets and liabilities. It involves mainly liquidity risk and interest rate risk which
along with default possibility (credit risk) leads to challenges for cash flow management
and to sustain the expectation of the stake holders.
Interest rate risk normally means adverse changes in the interest income due to market
volatility or interest rate volatility which ultimately affects the value of banks assets,
liabilities and off-balance sheet items. In this project interest rate risk management
initially involved understanding the changes in Net Interest Income under various

SUBARNA
GUPTA

ASSET LIABILITY MANAGEMENT 2009

situations of change in interest rate and then the types of interest rate risk are detailed
and interest rate risk management techniques and practices are discussed.
Besides, the project also includes overview of Foreign exchange risk management, fund
transfer pricing and the role of IT and software in ALM.
Finally, to have a detailed understanding of Structural liquidity and its impact on ALM
practices, a case study is developed. Due to the sensitive nature of data, a hypothetical
structural liquidity has been developed based on which an earnest effort has been made
to understand the asset and liability profile. In terms of the RBI regulations bank and
market specific scenario were applied on the hypothetical structural liquidity and
resultant position has been analyzed. Based on the outcome, possible courses of action
have also been indicated.
Statement of structural
liquidity under normal
scenario
Cumulative mismatch
as percentage to
cumulative outflows
Prudential limits

Day 1

287.43
%
-5.00%

2-7 Days

94.03%
-10.00%

8-14
Days

15-28
Days

83.37%
-15.00%

38.51%
-20.00%

29 Days
& upto 3
Months
-9.34%
-30.00%

Over 3
months &
upto 6
Months
-8.09%

Over 6
Months &
upto 1 Yr

Over 3 Yr
& upto 3
Yrs

-20.71%

-17.82%

-30.00%

-35.00%

-30.00%

Over 3
Yrs &
upto 5
Yrs
-8.15%

Above 5
Yrs

-15.00%

-10.00%

In the normal situation it was found that the bank has cumulative mismatch as
percentage of cumulative outflows ratios well within the prudential limits provided by RBI
and that the bank is dealing with short-term assets and long-term liabilities.
It could be concluded that
1. A conservative approach may be followed by the bank i.e. to hold funds rather
than deploy it so that it does not bear the risk to be a defaulter of payment.
2. There is no proactive asset management in place in the bank.
3. It is presumed that the bank has got the perception that interest rate will rise and
so it is not willing to lock funds in the long term to maximize the opportunity gain.
4. The bank has got decent deposit profile between 1-3 years bucket which shows
the confidence customers have in the bank.
Thus, although the bank has a comfortable liquidity position in the long term, it may
improve on its asset position in the long term by suitable deployment of funds so that
opportunity loss is minimized and NII is improved. Suggestions to improve on asset
management are:
1. Deploy funds in loan portfolio.
2. Deploy funds in floating rate government or corporate bonds.
Investments in floating rate bonds minimize the risk as floating rate bonds can be
hedged and two situations can be there:

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If the interest rate rises then the bank should not do anything as it is receiving
float and paying fixed.

If the interest rate falls, then the bank can hedge through Interest Rate Swap
(IRS) and receive fixed and pay float.

An investment under Government securities in fixed interest rate bonds also involves
two situations:

If the interest rate rises, the bank may receive float and pay fixed.

If the interest rate falls, then the bank may do nothing and continue to receive
fixed and pay float.

3. Deploy funds in floating rates linked with loans and advances.


Considering the reverse situation, in the normal scenario we get
Statement of
structural liquidity
under normal
scenario
Cumulative
mismatch as % to
cumulative outflows
Prudential limits

Day 1

-287.43%

-5.00%

2-7 Days

-94.03%

-10.00%

8-14
Days
-83.37%

-15.00%

15-28
Days
-38.51%

-20.00%

29 Days
& upto 3
Months
9.34%

-30.00%

Over 3
months &
upto 6
Months
8.09%

Over 6
Months &
upto 1 Yr

Over 3 Yr
& upto 3
Yrs

20.71%

17.82%

-30.00%

-35.00%

-30.00%

Over 3
Yrs &
upto 5
Yrs
8.15%

Above 5
Yrs

-15.00%

-10.00%

1.40%

It is found that the bank has leveraged short term liabilities with long term assets and
has strain in its immediate liquidity position. The bank has bridged the prudential limits
and is a completely outlier facing serious liquidity risk problems.
The options available to the bank are:
1. Bank may liquidate its assets i.e. loans and investments taking into account
the cost involved.
2. Bank may sell its investments even at loss considering the situation.
3. Bank may go for securitizations i.e. sell its loan portfolio.
4. Bank may tap known resources at very attractive rates for borrowing for 1 or 3
years or 3-6 months period.
Statement of
structural liquidity
under bank specific
crisis scenario
Cumulative
mismatch as % to
cumulative outflows
Prudential limits
(Normal Scenario)

Day 1

2-7 Days

8-14
Days

15-28
Days

29 Days
& upto 3
Months

Over 6
Months &
upto 1 Yr

Over 3 Yr
& upto 3
Yrs

-35.53%

Over 3
months &
upto 6
Months
-31.15%

-75.23%

-58.98%

-45.63%

-36.34%

-5.00%

-10.00%

-15.00%

-20.00%

Above 5
Yrs

-27.80%

Over 3
Yrs &
upto 5
Yrs
-14.04%

-39.72%

-30.00%

-30.00%

-35.00%

-30.00%

-15.00%

-10.00%

Applying the regulators assumptions for bank specific crisis scenario it was found that
the situation was quite grave with negative cumulative mismatch percentages beyond
the prudential limits in all but the last 3 maturity buckets. The bank has more RSLs than
RSAs in all the buckets and will be benefitted if the interest rate decreases.

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ASSET LIABILITY MANAGEMENT 2009

Thus, the possible options available to the bank are emergency borrowing for 1-2
months at a slightly higher rate than the prevailing market rate of interest, to raise the
interest rate suitably over and above the competitors to attract short term depositors, RBI
acting as the last resort of the bankers through liquidity adjustment facilities like reverse
repo, etc. Again, RBI may provide the bank with the liquidity support at the bank rate
under Collateralized Lending Facility (CLF) Bank may utilize the Export Refinance
Facilities provided by RBI to tide over temporary liquidity need. The bank may avoid
taking additional commitment, may judicially dispose its long-term investments at a
minimum cost, may sell its loan portfolio to other banks to raise funds, may try to borrow
from some of its clients with whom they enjoy good relations or may use relationship with
correspondent banks for short term requirements subject to prudential limits of 25% of
Tier I capital.
Statement of
structural liquidity
under market
specific scenario
Cumulative
mismatch as % to
cumulative outflows
Prudential limits
(Normal Scenario)

Day 1

2-7 Days

8-14
Days

15-28
Days

29 Days
& upto 3
Months

Over 6
Months &
upto 1 Yr

Over 3 Yr
& upto 3
Yrs

-20.99%

Over 3
months &
upto 6
Months
-17.92%

-45.98%

-30.41%

-14.00%

-8.34%

-5.00%

-10.00%

-15.00%

-20.00%

Above 5
Yrs

-19.23%

Over 3
Yrs &
upto 5
Yrs
-4.90%

-31.10%

-30.00%

-30.00%

-35.00%

-30.00%

-15.00%

-10.00%

Lastly, applying the regulators assumptions for market specific crisis scenario, it was
found that though there are negative mismatch percentages beyond the prudential limits,
the situation is not as grave as the bank specific crisis situation.
Under these circumstances, the options available to the bank are to approach RBI for
liquidity or RBI may tweak the CRR and or SLR as it happened during the Dec08
Quarter to infuse liquid funds/liquidity into the system. Again, RBI can increase refinance
facility.
Thus, it could be concluded that the bank exercises an overall conservative approach
which, if made more flexible to an extent, will help the bank better cope with either crisis
situations or mere fluctuations in the market.

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1.67%

ASSET LIABILITY MANAGEMENT 2009

CORPORATE PROFILE
Founded in 1943, UCO Bank is a commercial bank and a
Government of India Undertaking. Its Board of Directors consists of
government representatives from the Government of India and
Reserve Bank of India as well as eminent professionals like
accountants, management experts, economists, businessmen, etc.
Vision Statement
To emerge as the most trusted, admired and sought-after world class
financial institution and to be the most preferred destination for every
customer and investor and a place of pride for its employees.
Mission Statement
To be a Top-class Bank to achieve sustained growth of business and profitability, fulfilling
socio-economic obligations, excellence in customer service; through up gradation of
skills of staff and their effective participation making use of state-of-the-art technology.
Global banking has changed rapidly and UCO Bank has worked hard to adapt to these
changes. The bank looks forward to the future with excitement and a commitment to
bring greater benefits to you.
UCO Bank, with years of dedicated service to the Nation through active financial
participation in all segments of the economy - Agriculture, Industry, Trade & Commerce,
Service Sector, Infrastructure Sector etc., is keeping pace with the changing
environment. With a countrywide network of more than 2000 service units which
includes specialized and computerized branches in India and overseas, UCO Bank has
marched into the 21st Century matched with dynamism and growth!
Overview
The bank is in the Service of Community since 1943.
The bank has nearly 2000 Service Units spread all over India.
It also operates in two Major International Financial Centers namely Hong Kong
and Singapore.
UCO Bank has its Correspondents/Agency arrangements all over the world.
The bank undertakes Foreign Exchange Business in more than 50 Centers in
India.

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Strengths
Country-wide presence
Overseas Presence with Profitable Overseas Operations
Strong Capital Base
High Proportion of Long Term Liabilities
A Well Diversified Asset Portfolio
A Large and Diversified Client Base
Fully Computerized Branches at Major Centers
Branch representation in Top 100 Centers (as per deposits) in the country
Organization Structure
Headquartered in Kolkata, the Bank has 35 Regional Offices spread all over India.
Branches located in a geographical area report to the Regional Office having jurisdiction
over that area. These Regional Offices are headed by Senior Executives ranging up to
the rank of General Manager, depending on size of business and importance of location.
The Regional Offices report to General Managers functioning at Head Office in Kolkata.
Commitment to Customers
In all their promotional activities, the bank is fair and reasonable in highlighting the
salient features of the schemes marketed by them. Misleading or unfair highlighting of
any aspect of any scheme/service marketed by the Bank leading to unfair practice is not
resorted to by the Bank.
In their continuing endeavor to serve their customers better, the UCO Bank has
considerably extended the business hours for public transaction at the branches on all
week-days. The bank has also introduced a number of NO HOLIDAY branches. These
branches are open all 365 days a year. Besides, several of the branches have Express
DD Counter from where Demand Drafts can be purchased without any waiting time.
Products & Services
NRI Banking
Foreign Currency Loans
Finance/Services to Exporters
Finance/Services to Importers
Remittances
Forex & Treasury Services
Resident Foreign Currency (Domestic) Deposits
Correspondent Banking Services
General Banking Services

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ORGANIZATION STRUCTURE
Organisational Setup
Name of the Bank

UCO BANK

Address of the Banks Head 10, BTM Sarani, Kolkata 700


Office
001
Legal Structure

BANKING COMPANY

Share holding pattern

(% of Equity )

i)

GOI

60.59%

ii)

Public

14.56%

iii)

Others10.46%
Organisational Chart of the Bank

Source: UCO Bank website


Table I: Organizational Structure (UCO Bank)

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PURPOSE OF STUDY
The purpose of the project is to understand how the asset and liability of a bank is
managed and to highlight the importance it plays in achieving the Corporate Objective
i.e. optimizing the NIM with minimum calculated risk, taking into consideration the
business profile of the bank and the regulators guidelines.. The study also involves
understanding the practices of risk management as per the RBI guidelines and the
organizational set up thus developed and the roles and responsibilities of each involved
in asset liability management. Further, the objective is to proactively deal with asset
liability crisis situations and suggest probable solutions.

SCOPE OF STUDY
The study is based on PSU banks and the structural part of it is based on hypothetical
data developed based on UCO Bank. Since the data related to the details of asset
liability management of a bank is sensitive and beyond public domain, here
approximation of the asset liability statement of a PSU Bank is used and the RBI
assumptions of bank specific and market specific crisis are loaded on it to study the
situations and derive probable solutions.

METHODOLOGY
In order to arrive at the findings, essentially the techniques of evaluating the risks
involved in asset liability management as per the RBI guidelines are studied. For the
present study, the following served as the primary source of information:
The Reserve Bank of India guidance note on Asset Liability Management,
Asset Liability Management Policy of UCO Bank and
Various circulars issued by UCO Bank on the subject.
Based on these, hypothetical structural liquidity was developed on which crisis specific
scenario assumptions were applied to understand the outcome in stressed condition.

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P
17

ROJECT DETAILS

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ASSET LIABILITY MANAGEMENT 2009

INTRODUCTION
1.1 DEFINITION OF RISK
Risks are uncertainties resulting in adverse outcome, adverse in relation to planned
objective or expectations.
The term, risk is derived from the Latin word rischare meaning to run into danger.
In statistics, risk is often mapped to the probability of some event which is seen as
undesirable.

1.2 RELATION BETWEEN RISK & RETURN


Corporations operate in a dynamic environment and hence the future remains uncertain
to a large extent. With the help of probability theory and careful evaluation of the
environment, companies are now able to predict, to some extent, the various risks that
may have a critical impact on their business.
There are many reasons for business firms to take risks, primary need being profit
motivation and maximize shareholders wealth. Risk is important to earn reward. Risk in
a business or investment is netted against the return from it. There is direct relation
between risk and reward. The potential return rises with an increase in risk. Low levels of
uncertainty (low risk) are associated with low potential returns, whereas high levels of
uncertainty (high risk) are associated with high potential returns. According to the riskreturn tradeoff, invested money can render higher profits only if it is subject to the
possibility of being lost. Taking on some risk is the price of achieving returns; therefore, if
you want to make money, you can't cut out all risk. The goal instead is to find an
appropriate balance.
Hence Risk optimization and not risk elimination should be the prime goal of Risk
Management.

Figure II: Graph showing risk return trade-off

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RISK IN CONTEXT OF BANKING


SECTOR
Banks are financial intermediaries. They are confronted with various kinds of financial
and non-financial risks viz., credit, interest rate, foreign exchange rate, liquidity, equity
price, commodity price, legal, regulatory, reputational, operational, etc. These risks are
highly interdependent and events that affect one area of risk can have ramifications for a
range of other risk categories. Thus, top management of banks needs to attach
considerable importance to improve the ability to identify measure, monitor and control
the overall level of risks undertaken.
Banking risk management is both a philosophical and operational issue. As a
philosophical issue, banking risk management is about attitudes toward risk and the pay
off associated with it, and strategies in dealing with them. As an operational issue, risk
management is about the identification and classification of banking risks, and methods
and procedures to measure, monitor and control them (Angelopoulos and
Mourdoukoutas, 2001, p. 11)
So far as banking business is concerned, the business lines can be regrouped into 3
categories on the basis of risk associated with them. These are:1. Risk to the banking books: The banking book includes all types of deposits,
loans and borrowings on account of all commercial and retail banking
transactions. The types of risk associated with such exposures are mainly Credit
Risk and Operational Risk and to some extent Market Risk.
2. Risk to the trading books: The trading book includes all marketable assets, i.e.
investment in all types of securities, equities, foreign exchange assets. The types
of risks associated with such exposures are mainly Market Risk, Credit
Risk/Default Risk and Operational Risk.
3. Risk to Off-balance sheet items: The off-balance sheet exposure includes bank
guarantees, letter of credits, derivative instruments like futures, options, swaps,
forward contracts, etc. These are contingent exposures which can turn out to be
fund based exposures and attract all risk associated with the banking books and
trading books.

2.1 TYPES OF RISKS


Different types of risk inherent in banking and financial services are:
2.1.1 CREDIT RISK: Risk of loss due to a debtor's non-payment of a loan or other
line of credit (either the principal or interest (coupon) or both).

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Banks are in the business of taking credit risk as their business is to lend to borrowers
with different risk category at a premium than the zero risk rate. There is always a
chance that a borrower/counter party may fail to honour his commitment to pay as a
result of which the credit risk crystallizes to the bank.
The responsibility of managing credit risk lies with the Credit Risk Management
Committee.
Financial Contracts designed to transfer credit risk on loans and advances, investments
and other assets and exposures from one party to another are called Credit Derivatives.
The different types of credit risk are:
Default Risk- It is the risk of non-recovery of sums due from outsiders,
which may arise either due to their inability to pay or unwillingness to do
so.
Credit Spread Risk or Down grade Risk- It results when rating agencies
lower their rating on a bond resulting in decline in the bond prices.
Counterparty Risk- It is the inability or unwillingness of a customer or a
counter party to meet the commitments in relation to lending/ trading/
hedging/ settlement or any other financial transaction.
Country Risk- Those changes in the business environment which
adversely affect operating profits or the value of assets in a specific
country are referred to as Country Risk.
2.1.2 MARKET RISK: The possibility of loss arising out of any adverse change in the
market variables like interest rate, exchange rate, equity price, commodity price
etc are called Market Risk.
Market risk is more visible in Trading Activities [like debt instruments, equity, foreign
exchange, commodity, etc] than in advance portfolio of the banks.
At the corporate level the Asset and Liability Management Committee [ALCO] is
responsible for the management of the market risk.
Market risk is again of the following types:
i.
Interest rate risk:
The possibility of loss due to the change in the interest rate in the market is called
Interest Rate Risk. This loss involves both the net interest income to the bank and also
the erosion in the value of the securities affecting the net worth of the bank due to more
provision/Loss.
Interest Rate Risk can be further divided into:
a) Gap or Mismatch Risk:
b) Basis Risk:
c) Embedded Option Risk:

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d) Reinvestment Risk:
e) Price Risk:
These are explained in details in the following chapters.
ii.

Liquidity risk:

The inability to honour the withdrawals and commitments is called Liquidity Risk. It is the
risk of cash shortage when it is needed. It arises from maturity mismatch.
It involves
a) Funding Risk,
b) Time Risk and
c) Call Risk.
These are explained in details in the following chapters.
iii.

Foreign exchange risk:

It is the risk that a bank may suffer losses as a result of adverse exchange rate
movements during a period in which it has an open position, either spot or forward, or a
combination of the two, in an individual foreign currency.

2.1.3. OPERATIONAL RISK: This is defined as The Risk Direct or Indirect Loss
resulting
from Inadequate or Failed Internal Process, People and System or from External Events.
The operational risk can be further divided into the following types:
Fraud Risk-. Risks due to any fraud, forgery by internal as well as
external sources are referred to as Fraud Risk.
Communication Risk- Risk due to any inconvenience caused as a result
of miscommunication or misunderstanding is known as Communication
Risk.
Documentation Risk- It is the probability of loss that a legal agreement
may turn out to be incomplete, insufficient, or otherwise unenforceable.
Transaction Risk- It is the risk arising from fraud, both internal and
external, failed business processes and the inability to maintain business
continuity and manage information.
Legal Risk- It is the risk that legal systems will expropriate value from
shareholders
Competence Risk- It is the risk arising from an awareness of one's
limitations in both experience and knowledge and a willingness to
supplement existing experience and knowledge.
Model Risk- A type of risk that occurs when a financial model used to
measure a firm's market risks or value transactions does not perform the
tasks or capture the risks, it was designed to.

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Technology Risk: The risk of loss due to system failure, system security,
programming errors, telecommunication error, absence of disaster
recovery plan, computer related frauds, etc is called Technology Risk.
Reputation Risk: It is the negative public opinion impacting the depositors
and market confidence on the bank and thus the loss of business.
Cultural Risk- Cultural risks occur as the result of different expectations,
misunderstandings and miscommunications between a buyer and the
seller of products/ services.
External Events Risk- It comprises of variety of pitfalls that can affect a
companys ability to repay its debt obligations on time. It may be due to
poor management, change in management, failure to anticipate shifts in
companys market, rising cost of raw materials, regulations and new
competition, etc.
Management Risk: The risk of loss due to wrong business decisions,
improper implementations of decisions, lack of responsiveness to industry
changes is called Management Risk
Regulatory Risk- It is the risk that statute or a policy of a regulatory body
conflicts with intended transaction
Compliance Risk- It is the risk of legal or regulatory sanction, financial
loss or reputation loss that a bank may suffer as a result of its failure to
comply with any or all of the applicable laws, regulations, code of conduct
and standards of good practice.
At the corporate level, the Operational Risk Management Committee [ORMC] is
responsible for the management of operational risk.

TRANSACTIONS

PARTICIPANTS

RISKS EXPOSED TO

foreign currency loans


fixed interest rate loan
variable rate loan
variable rate loan
Short-term loan
Equities

foreign investor
Domestic borrower
(foreign) lender
domestic borrower
(foreign) lender greater
domestic borrower
(foreign) investor

Interest rate risk, credit risk


exchange rate risk
Interest rate risk
interest rate risk
credit risk
refunding or liquidity risk
Credit risk; market risk from
changes in exchange rate; market
price of the stock.

Bonds

(foreign) investor

Credit risk and market investment


risk.

Hard currency bonds


domestic borrower
Table II: Some probable risk scenarios

2
2

Exchange rate risk.

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RISK MANAGEMENT
Risk management is the systematic process of identifying the risks the business faces,
evaluating them according to the likelihood of their occurrence and the damage that
could ensue, deciding whether to bear the risk, avoid the risk, control the risk or insure
against the risk [or any combination of these four], allocating responsibility for dealing
with them, ensuring that the process actually works, and reporting material problems as
quickly as possible to the right level. All financial intermediation entails the assumption,
management and pricing of risk.

3.1 KEY FACTORS IN THE EVOLUTION OF


FINANCIAL
INSTITUTION RISK MANAGEMENT PRACTISE:
Several factors have contributed to the increased focus on risk management:
Term disintermediation between maturing assets and liabilities.
Market volatility.
Interest rate volatility.
Default possibilities.
The deregulation of financial markets.
The increasing role of securities and derivative products in financial
intermediation.
The increase in the risk profiles of organizations, with increased emphasis on
activities which require the assumption of risk, deliberately.
The volatility of markets and its impact on financial institutions.
The pressure from capital market investors for returns related to the relative
riskiness of their investments and
The regulatory requirements for a framework for the management of risk.

3.2 STEPS INVOLVED IN RISK MANGEMENT


Risk management therefore involves three steps:
1) Identification of all types of risks the business can face and thus prepare a Risk
Profile.
2) Measurement of these risks.
3) Taking measures to control and monitor risk.
Identification of risk: The method of listing risk and grouping them into logical groups is
called identification of risk or risk analysis .This leads to the preparation of a risk profile
of the organization. The RBI has provided templates for finding out the Risk Profiles of
the bank. The Risk profile of the bank has to be constructed and be reviewed at
quarterly intervals.

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Measurement of risk: There are different methods of measurement of risk. Some of


them are: Uncertainty Analysis, Sensitivity Analysis and Probability Analysis. All these
methods are statistical methods and therefore require adequate, reliable unbiased data
base.
Taking measures to monitor and control risk: The different types of risks can be
managed by choosing to bear the risk, avoid the risk, control the risk or insure the risk or
a combination of any of these.

3.3 TECHNIQUES OF RISK MANAGEMENT


Managing risk is a very important area of concern in Risk Management. These
techniques include:
(a) Risk avoidance,
(b) Risk reduction,
(c) Risk maintenance and
(d) Risk transfer.
It is a priority to decide which technique to use for which risk. The scope of a decision varies
in each organization. The extent of potential loss, its probability as well as the cost involved
in each of the techniques are the critical factors in deciding the course of action.

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ASSET LIABILITY MANAGEMENT [ALM] &


ITS
IMPORTANCE IN BANKS
4.1 DEFINITION
Asset Liability Management, an important risk management, is defined as the strategic
management of assets and liabilities in the balance sheet in such a way that the netearning from interests is maximized and Liquidity Risk and Interest Rate Risk are
minimized. It is the process of adjusting bank liabilities to meet loan demands, liquidity
needs and safety requirements.
It is mandatory now for banks since April 01, 1999.
Date

Table III:

4.2

Event

State of ALM

Pre-1960s

Asset Management and Portfolio


Matching

1961

Advent of Liability Management

1975

Stagflation

Birth of GAP Analysis

1982

PCs

Advent of Simulations

1984

Value recognition

Duration Analysis

1988

Options proliferation

Prepayments Models

Now

Complexity and Rope

Integrated Risk Management

ALM History

IMPORTAN
CE

OF

ASSET

LIABILITY MANAGEME
NT

A vital issue in strategic management of Banks Balance Sheet, is asset and liability
management (ALM), which is the assessment and management of endogenous-financial, operational, business--and exogenous risks. The objective of ALM is to
maximize returns through efficient fund allocation given an acceptable risk structure.
ALM is a multidimensional process, requiring simultaneous interactions among different
dimensions. If the simultaneous nature of ALM is discarded then decreasing risk in one
dimension may result in unexpected increases in other risks.
ALM has changed significantly in the past two decades with the growth and integration
of financial institutions and the emergence of new financial products and services. New
information-based activities and financial innovation increased types of endogenous and
exogenous risks as well as the correlation between these. Consequently, the structure of
balance sheet instruments has become more complex and the volatility in the banking

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system has increased. These developments necessitate the use of quantitative skills to
manage risks more objectively and improve performance.

4.3 SIGNIFICANCE OF ALM


Significance of ALM lies in addressing the risks arising out of changes in interest rates,
exchange rates and credit risk and liquidity position of the bank in the balance sheet of
the bank. Reasons for growing significance of ALM are:
Term intermediation: Term intermediation between maturity of assets and
liabilities exposes the bank to liquidity risk which requires proper management of
the assets and liabilities.
Volatility: Free economic environment often leads to fluctuations in rates
reflected in the interest rate structure, money supply and overall credit position of
the market. These affect the market value of the bank and its Net Interest
Income.
Product Innovation of financial products of the bank imparts effect on the risk
profile of the bank.
Regulatory Environment: BIS (Bank for International Settlements) provides
framework to banks for coping with risk arising out of excessive credit risk and
rate fluctuations. Thus, like other Central Banks, RBI in India has provided
guidelines to banks to adopt ALM.
Management Recognition: All these reasons resulted in serious attitude of
management towards relating the asset and liability side of Balance sheet and
thus efficient ALM is required.
Cross border transaction and seamless integration of domestic and global
markets also leads to chances of risk as is found recently in the case of Lehman
Brothers which in course of time, affected the global economy as a whole.

4.4 PARAMETERS
FOR
LIABILITY MANAGEMENT:

STABILIZING

ASSET

Liquidity: Whether the liquidity situation is healthy and under control is the basic
parameter to stabilize the asset liability management.
Net Interest Income: Interest income interest expenses.
It measures effect of fluctuations in rates on short-term profits.
Net Interest Margin: Net interest income divided by average total asset.
Higher the spread between total interest income and the total interest expense,
higher the net interest income and thus, higher the net interest margin.
Economic Equity Ratio: Ratio of shareholders funds to the total assets.
It measures the shifts in the ratio of owned funds to total funds.

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ALM ORGANIZATIONAL STRUCTURE


The Asset Liability Management Committee (ALCO) should function as the top
operational unit for managing the balance sheet within the performance/risk parameters
laid down by the Board according to the RBI guidelines.
Ideally, the organization set up for Market Risk Management should be as under
The Board of Directors
The Risk Management Committee
The Asset-Liability Management Committee (ALCO)
The ALM support group/ Market Risk Group

5.1 COMPOSITOPN OF ALCO


The CEO/CMD or the ED should head the Committee.
The Chiefs of
Investment,
Credit & Credit Monitoring
Finance/Resources
Management or Planning,
Funds Management / Treasury (forex and domestic),
International Banking and
Economic Research can be members of the Committee.
In addition, the Head of the Technology Division should also be an invitee for
building up of MIS and related computerization. Some banks may even have
Sub-committees and Support Groups.

5.2 THE MIDDLE OFFICE


Ideally Middle office acts as ALCOs secretariat, reporting directly to ALCO and
monitoring abidance of organizational operations to the guidelines and mandate
provided by the Board.
Banks without formal Middle Offices must ensure that risk control and analysis should
rest with a department with clear reporting independence from Treasury or risk taking
units, until formal Middle Office frameworks are established.
The Middle Office is responsible for the critical functions as follows:
independent
market
risk
monitoring, measurement,
research, analysis and reporting for the bank's ALCO.

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An effective Middle Office provides the independent risk assessment which is critical to
ALCO's key-function of controlling and managing market risks in accordance with the
mandate established by the Board/Risk Management Committee.
The methodology of analysis and reporting varies from bank to bank depending on their
degree of sophistication and exposure to market risks and which may vary from
simple gap analysis to
Computerized VaR modelling.

5.3 THE DEALING ROOM


The Dealing Room acts as the bank's interface to international and domestic financial
markets and is responsible for meeting the needs of business units in pricing market
risks for application to its products and services.
The Dealing Room is responsible for meeting the needs of business units in pricing
market risks for application to its products and services.

5.4 THE BACK OFFICE


The Back Office is responsible for issuing and receiving confirmations for transactions
concluded by the Dealing Room.
The various functions of the back office are:
The control over confirmations both inward and outward: All confirmations for
transactions concluded by the Dealing Room must be issued and received by the Back
Office only. Discrepancies in transaction details, non-receipts and receipts of
confirmations without application are resolved promptly to avoid instances of unrecorded
risk exposure.
The control over dealing accounts (vostros and nostros): Prompt reconciliation of all
dealing accounts is an essential control to ensure accurate identification of risk
exposures. Unreconciled items and discrepancies in these accounts must be kept under
heightened management supervision as such discrepancies may at times have
significant liquidity impacts, represent unrecognized risk exposures, or at worst
represent collusion or fraud.
Revaluations and marking-to-market of market risk exposures: All market rates
used by the bank for marking risk exposures to market used to revalue assets or for risk
analysis models such as Value at Risk analysis, are sourced independently of the
Dealing Room to provide an independent risk and performance assessment. If the bank
has an established and independent Middle Office function, this responsibility may
properly pass to the Middle Office.

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Monitoring and reporting of risk limits and usage: Reporting of usage of risk against
limits (such as counterparty limits, overnight limits etc.) established by the Risk
Management Committee, maintenance of all limit system and access to limit system are
maintained by the Back Office independently of the Dealing Room.
Control over payments systems: The procedures and systems for making payments
are under at least dual control in the Back Office independent from the dealing function.

5.5 FUNCTIONS OF ALM: ROLES AND RESPONSIBILITIES


Management of market risk is among the major concerns of top management of banks.
The Boards should clearly articulate market risk management policies, procedures,
prudential risk limits, review mechanisms and reporting and auditing systems. The
policies should address the banks exposure on a consolidated basis and clearly
articulate the risk measurement systems that capture all material sources of market risk
and assess the effects on the bank. The operating prudential limits and the
accountability of the line management should also be clearly defined.
Successful implementation of any risk management process emanates from the top
management in the bank and its strong commitment to integrate basic operations and
strategic decision making with risk management.
1. The Board of Directors should have the overall responsibility for management of
risks. The Board should decide the risk management policy of the bank and set limits
for liquidity, interest rate, foreign exchange and equity price risks.
2. The ALCO (Asset Liability Committee) should be responsible for ensuring adherence
to the limits set by the Board as well as for deciding the business strategy of the bank
in line with banks budget and decided risk management objectives. The ALCO is a
decision-making unit responsible for balance sheet planning from risk-return
perspective including strategic management of interest rate and liquidity risks. The
role of the ALCO should include, inter alia, the following :
product pricing for deposits and advances
deciding on desired maturity profile and mix of incremental assets and liabilities
articulating interest rate view of the bank and deciding on the future business
strategy
reviewing and articulating funding policy
reviewing economic and political impact on the balance sheet

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ALM PROCESS
The ALM process rests on three pillars:
o ALM Information Systems
Management Information Systems
Information availability, accuracy, adequacy and expediency
o ALM Organisation
Structure and responsibilities
Level of top management involvement
o ALM Process
Risk parameters
Risk identification
Risk measurement
Risk management
Risk policies and tolerance levels.

ALM Information System


A proper management information system provides accurate and adequate information
to the ALM system and this requires extensive computerization of the bank, so that the
requisite information becomes readily available. The details of importance and
application of IT and software in this regard are discussed in following chapter.
.
ALM Organization
The Board of Directors have the overall responsibility for the ALM & risk management
and lay down the tolerance limits for liquidity and interest rate risk in line with the
organizations philosophy. However, the Asset Liability Committee (ALCO) is responsible
for deciding on the business strategies consistent with the laid down policies and for
operatinalising them.
Typically, ALCO consists of the senior management, including the Chief Executive.
ALCO is supported by an efficient analytics providing detailed analysis, forecasts,
scenario analysis and recommendation for action. ALCO not only makes business
decisions, but also monitors their implementation and their impact. Further, it also takes
action and initiates changes in response to the market dynamics. ALCO Support Group
will provide the data analysis, forecasts and scenario analysis for ALCO.
This relevant data, its collection and flow of information for formulation of STL statement
as well as for monitoring the overall ALM process and functioning in the bank, the
organizational set up functions as follows:

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Board of Directors
Risk Management committee
ALCO
ALM cell
Financial planning department
Credit analysis department

Credit risk management department

Middle office

Treasury
Back Office
Front Office

Investment and loan department

Fig II: Flow of information towards decision making in ALM

ALM Process
The scope of the ALM function typically covers liquidity risk management, market risk
management, funding and capital planning and profit planning & road projection. The
RBI has laid down detailed guidelines for asset liability management in 1999. Their focus
is mainly on liquidity and interest rates risks. The guidelines specify the use of a maturity
ladder upto 8 time buckets and calculation of cumulative surplus or deficit of funds at
selected maturity dates is adopted as a standard tool. The formats of statement of
structural liquidity are given by the Reserve Bank of India. Detailed guidance also is
given for the classification of the assets & liabilities in each time bucket provided in
annexure II. Guidelines also provide a format for estimating short-term dynamic liquidity
in a time horizon spanning one day to six months. This tool is to be used for estimating
short-term liquidity profiles on the basis of business projections and other commitments.
The gap i.e., the difference between rate sensitive assets and rate sensitive liabilities is
to be used as a measure of interest rate sensitivity. The guidelines also provide
benchmarks about the classification of various components of assets and liabilities into
different time buckets for preparation of GAP reports. However, the bank needs to
estimate the future behavior of assets and liabilities and off--balance sheet items in
response to changes in market variables and also the probabilities of options on internal
transfer pricing model for assigning values for funds sourced and funds used for
operating their ALM system. In fact, such estimates provide a rational framework for
pricing of assets and liabilities.

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Risk Measurement and Board Reporting: Risk Measurement


The following are minimum risk and performance measures of ALM, required by sound
business and financial practices:
Periodic measurement of overall balance sheet mix.
Periodic measurement of asset, liability and capital growth or decline.
Periodic measurement of operational cash flows.
Periodic measurement of financial margin.
Periodic measurement or projection of the impact of interest movements.
Periodic measurement of the level of unhedged foreign currency funds.
Periodic assessment of the appropriateness of financial derivatives held.
The credit union must also meet ALM measurement requirements set out in the Act and
Regulations. The credit union may track any other measures of the loan portfolio as it
sees fit.
These measurements are compared to financial targets in the annual business plan and
the budget and the management determines whether the bank is meeting its goals.
Management can also assess whether there are material variances from the plan which
need to be addressed. Comparison of these measurements against historical
performance, where possible, also identifies significant trends which may need to be
addressed by management.
Variances from the business plan in the volume and mix of loans, investments and
deposits, are also measured and monitored as this could have serious effects on net
financial margin. Different types of loan and investment categories will provide different
yields. Measurement of the portfolio mix can alert management to future declining
margins caused by an unfavourable shift towards lower yielding loans. Conversely,
higher than expected asset yields could reflect an undesired shift toward higher risk
loans and investments. Written explanations for changes in mix and yields should be
provided by management to the board for its periodic review of the financial statements.
The average costs of other sources of funding (borrowings and equity) should be
monitored at least quarterly by board and management to determine if they are
reasonable. Where interest/dividends are paid to members at the end of the year, these
should be estimated and accrued for interim reporting.
Structural Liquidity Risk
Liquidity risk is the inability to meet commitments more pronounced in the short term.
Maturity Profiles of inflows and outflows which are mostly not matched cause structural
liquidity problems. Structural Liquidity risk is measured in multiple ways. A realistic
measure is an absolute value of gap between inflows and outflows by maturity bucket..
Interest Rate Risk
Gap between interest rate sensitive assets and liabilities, spread over time is a
measurement of market risk. This measure is a basic measurement technique.
Sensitivity of Net Interest Income (NII) to interest rate change is another way of
measuring the interest rate risk. The Basel Committee on Bank Supervision stipulates

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the benchmark in this regard as the 200 basis points parallel shift in yield curve.
However, central banks of individual countries have the freedom to vary this norm.

Inadequacy of balance sheet analysis for ALM


ALM techniques are used over and above balance sheet techniques. First of all, ALM
takes into account the time value of money whereas balance sheet accounting ignores
time element. Secondly, ALM requires factoring the off-balance sheet items to estimate
their potential impact on the banks e.g., unutilized portion of cash credit. Further, the
ALM involves holistic perspective for decision-making and factors in the market
dynamics.
Mapping Non-term products
Certain products like savings bank have no contracted maturity terms. Therefore, there
is conceptual difficulty in mapping them into zero coupon bonds as the timing of the
occurrence of such cash flows is not known. They are generally split into two or more
parts based on their behaviour. These parts are volatile and core. Core is expected to be
with the bank and will report in later time buckets. Volatile portion is typically assigned to
the first bucket.
Probabilistic cash flow products
Savings bank and current account are examples form the banking book of probabilistic
cash flow behaviour. Probability is deliberate in derivative class of instruments. Thus,
complex and sophisticated models are required to map derivative type of instruments
into the cash flow model.
Options, Futures and derivatives
Bank uses these instruments to hedge positions. To offer a customer a long position in
Rupees at a certain rate, bank has to hedge by taking a corresponding short position.
Thus, regardless of Rupees rate changes, bank is fully protected, offering customer
protection as well. Options, futures and derivatives may be used to take positions, apart
from hedging. Basel II norms specify different treatments for the derivatives.
Transfer Pricing for Measuring Profitability
Profitability by business units, as given out by simple balance sheet is distorted. A
business unit or a branch located in a residential area is by definition a deposit-taking
branch. Thus, its profitability should be measured by efficiency of deposit collection i.e.,
weighted average interest rates of deposit collection by time buckets compared to a
standard yield curve. Thus, concept of funds transfer pricing has emerged strongly in the
past few years.
Strategising ALM Framework
ALM policy is drafted and updated by banks ALCO. ALM policy requires that board of
directors, Asset Liability committee follow a formal procedure. ALM Policy covers banks
position on all risks credit risk, market risk, liquidity risk etc. Banking keeps changing

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and in times will change even further. Thus, ALM policies need to change with the
changes in the market on a continuous basis. This ensures that practices are current,
though business itself does not change. In India, for example, for a large number of
years, it was liability creation that was the prime driver. Once bank gathered enough
funds, the banks would look at multiple asset creation avenues. However, of late, it is the
asset creation that drives the liability growth.

Product
Both assets and liabilities are considered products and operational parameters defined
for both. For example, deposits may have various characteristics and structures for
interest rates. Competition may introduce new products based on their ALM positions.
The policy defines products that the bank may deal in both on assets and liabilities.
Complexities are introduced by options both explicit and embedded. Savings bank and
cash credit is a classic case of embedded options. Thus, ALCO needs to understand
impact of probabilistic cash flows before approving such products. Before being offered,
product creation needs to go through a proper introduction and approval mechanisms
through Risk Management and ALCO. Thus, policy should address parameters that
should never be crossed.
Structural Liquidity
Structural liquidity is critical for an institution. Therefore, policies are laid out for
measurement and implementation of liquidity controls in any financial institution.
Individuals practice structural liquidity measurement and control for personal portfolios.
Hence, these are even more vital for a financial organization.
Gap Measurement
Time buckets are defined as a maturity bucket scheme. All cash flows are mapped to
corresponding buckets. Thus, entire portfolio of cash flows is now reduced to a bucket
representation, thus making it easier to analyse.
Since all products are mapped, assets represent all inflows and liabilities represent all
outflows. Thus gaps in each time bucket are analysed. Regulators specify use of
percentage of tolerance for gaps. Practical bankers use an absolute amount.
Thus, as long as gap remains within tolerance, it is within known manageable limits.
There cannot be zero gap in ideal situation.
Cost to close gap
This is another measurement for structural liquidity. The last bucket is closed first using
market interest rate for that bucket. Some implementations divide all buckets to months
internally and calculate cost to close at month level. Cost to close of the last bucket is
them taken as an outflow in the previous bucket and that closed and so on all the way till
the first bucket is closed. That gives the total cost to close gap.
The other way is to simply calculate cost to close gap for each bucket based on interest
rate and assuming that all cash flows occur at the gap median.

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Tolerance to limits of cost to close is defined as a measure of structural liquidity risk and
this is used for control.

Scenario Analysis
Liquidity analysis scenarios are generated. A typical measure would involve worst case,
best case and likely. These scenarios are scrutinized and their impact approved by
ALCO as a matter of routine. All analysis referred to above provide measures enabled by
these scenarios.
Many banks, as a matter of routine, create scenarios on top of native cash flows. They
alter nature of native cash flows based on their prior knowledge. Derived cash flows are
indeed scenarios that have been pre-defined.
Interest rate risk
Interest rate risk is measured using traditional techniques for measurement of market
risk. Market risk exists due to volatility of interest rates. Financial institutions make
money as they take market risk.
Interest rate Gap
Interest rate gap of a bucket is calculated in a manner similar to liquidity gap. Tolerance
of gap in terms of percentage, absolute values is a risk control measure. Tolerance
provides control point as well.
NII Sensitivity analysis
Sensitivity of Net Interest Income to movement in interest rates may be determined by
assuming a change in the interest on assets/liabilities. It is assumed that 100% of assets
and liabilities will get re-priced. This may not be realistic and re-pricing % is a parameter
that must be determined by banks behaviour. Thus, sensitivity of NII to interest rate
movement and interest rate shocks are a interest rate risk measure that may be used.
Unlike duration, this is more simplistic and will not carry the concept of time value of
money.
Scenario Analysis
Interest rate sensitivity analysis scenarios are generated. A typical measure would
involve worst case drop in NII - rate shock of x% on cost and y% on yield, best case and
likely. These scenarios are scrutinized and their impact approved by ALCO as a matter
of routine. All analysis referred to above may be measured for above scenarios.
Many banks, as a matter of routine, create scenarios on top of native cash flows. They
alter nature of native cash flows based on their prior knowledge. Derived cash flows are,
indeed, scenarios that have been pre-defined.
Implementation Issues: Policy
Lack of a coherent, documented and practical policy is a big hindrance to ALM
implementation. Most often, ALCO membership itself may not be aware of implications of
risks being measured and impact. Policies address all issues concerning the bank and

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are clearly explained to all members of board, apart from ALCO and these are
documented. Proper revisions to this document, a quarterly review needs are organized
as well as parameters may be changing due to change in situations.

Organization and culture


ALM function needs to be separated clearly from operations as it involves control and
strategy functions. Risk organization in banks generally land up reporting to treasury, as
they are people who come closest to understanding complex financial instruments. The
fact that they are a business unit, in charge of risk taking is overlooked. Risk Taking
and Risk management are generally two distinct parts of any organization and both
must report to a board completely independently.
Openness and transparency are essential to a proper risk organization. Most
organizations react badly to some positions going wrong by taking more risks and enter
vicious cycle of risks. Thus, it is required to follow policy implicitly in both letter and spirit.
Most dramatic failures in the last decade have not been because of market risk or credit
risk but bad risk management organizations. This must be a big pointer to boards and
ALCOs on avoidance of such issues.
Data and models
Data is not available at all times in requisite format. Many data items are assumptions as
for e.g. the case of a manual branch of a bank that was closed for some period in a year
due to riot/strike/bandhs/natural diaster completely destroying the data base. As data
may not be obtained from this branch for some period still data is recovered /restored,
appropriate assumptions has to be made. The argument is that for all other purposes,
assumptions are being made.
Risk Management: Corrective Action
An important activity in the effective management of risk is management's timely
response to unauthorized risk or poor performance developments. As a follow up to the
asset/liability risk measurements taken by the bank, management should investigate all
significant performance variances relative to the annual business plan and to historical
performance, and respond by taking action to correct these variances. Management
must similarly respond to any contravention of board policy or regulatory requirements,
or other unauthorized risk.
Operational Procedures
Procedures can assist management in ensuring regulatory and policy requirements are
met with respect to asset/liability mix, interest rate risk exposure, foreign exchange rate
exposure, and derivatives use.
To assist in implementation, procedures should be both appropriate and cost effective
given the size of the credit union's operations.
It is a sound business and financial practice for credit unions to document procedures.
Written procedures result in higher staff productivity and better control over resources.

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MANAGEMENT OF LIQUIDITY RISK

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Banks liquidity management is the process of generating funds to meet


contractual or relationship obligations at reasonable prices at all times.
Measuring and managing liquidity needs are vital activities of commercial banks. By
assuring a banks ability to meet its liabilities as they become due, Liquidity Management
can reduce the probability of developing adverse situations. Banks normally keep their
liquid funds in Cash and Balance with RBI, Balance with other banks. Money at Call and
Short Notice and in Investments. To meet the liquidity gap, banks adjust their surplus /
deficit by investing the surplus funds in short / long term securities and by disinvesting
securities or by borrowing funds from the market to meet the shortfall.
OUTFLOWS

INFLOWS

Capital

Cash

Reserve and surplus

Balances with RBI

Deposits

Balances with other banks

Borrowings

Investments

Other liabilities and provisions

Advances(performing)

Lines of credit committed

NPAs(Advances and Investments)

Unavailed portion of cash credit / overdraft

Fixed assets

Letters of credit / guarantees

Other assets

Repos

Reverse Repos

Bills rediscounted

Bills rediscounted

Swaps

Interest receivable

Interest payable

Committed lines of credit

Others

Export refinance from RBI


Others

Table IV: Composition of Liquid Fund

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7.1 ADEQUACY OF LIQUIDITY POSITION FOR A BANK


A banks adequacy of liquidity position can be determined by analyzing the following
factors:
a. Historical Funding requirement
b. Current liquidity position
c. Anticipated future funding needs
d. Sources of funds
e. Options for reducing funding needs
f. Present and anticipated asset quality
g. Present and future earning capacity and
h. Present and planned capital position
Proper analysis of these factors leads to effective liquidity management which helps the
bank to
Maintain credibility in the market
Meet its formal and informal prior loan commitments
Avoid unprofitable sale of assets
Lower the size of default risk premium to be paid for funds

7.2 SOURCES OF LIQUIDITY RISK


Liquidity Exposure can stem from both internally and externally.

External liquidity risk can be geographic, systemic or instrument specific.

Internal liquidity risk relates largely to perceptions of an institution in its various


markets: local, regional, national or international

7.3 TYPES OF LIQUIDITY RISK

Funding Risk: It arises from the need to replace net outflows due to
unanticipated withdrawals/non-renewal of deposits; the respective sources can
be:
o Fraud causing substantial loss
o Systematic Risk
o Loss of confidence
o Liability in foreign currencies

Time Risk: It arises from the need to compensate for non-receipt of expected
inflows of funds; it can stem from:
o

Severe deterioration in the asset quality

o Standard assets turning into non-performing assets


o Temporary problems in recovery

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Time involved in managing liquidity

Call Risk: It arises from crystallization of contingent liability; the sources can be:
o

Conversion of non-fund based limit into fund-based

Swaps and options

7.4

MEASURING AND MANAGING LIQUIDITY RISK

This can be done through the following 2 approaches:


1. Stock Approach
2. Cash Flow Approach

7.4.1 Stock Approach


This is based on the level of assets and liabilities as well as off balance sheet
exposures on a particular date. The following ratios are calculated to assess the
liquidity position
i) Ratio of core deposit to total assets- Higher value of ratio is appreciated as
core deposits (deposits from the public) are stable source of liquidity.
ii) Net loans to total deposits ratio-Lower the ratio, the better since loan is
treated to be less liquid asset and here net loan means net advances after
deduction of provision for loan losses and interest suspense account.

iii) Ratio of time deposits to total deposits-Time deposits () provide stable level of
liquidity and less volatility. So, higher the ratio the better it is.
iv) Ratio of volatile liabilities to total assets high proportion of volatile assets
cause higher liquidity problem and as a result lower the ratio the better it is.

v) Ratio of short-term liabilities to liquid assets Short term liability requires


ready liquid assets to meet the liability. Hence the ratio is expected to be
lower.
vi) Ratio of liquid assets to total assets- As higher level of liquid assets ensure
better liquidity, So higher ratio is expected.
vii) Ratio of short-term liabilities to total assets- A lower ratio is desirable since
short-term liabilities include balances in current account, volatile portion of
savings.

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viii)Ratio of prime asset to total asset- Prime asset includes cash balances or
balances with banks or RBI which can be withdrawn at any time without
notice. Hence higher ratio is desirable.

ix) Ratio of market liabilities to total assets- Lower ratio is preferred as market
liabilities include money market borrowings; inter bank liabilities repayable
within a short period.

7.4.2 Cash Flow Approach


While the liquidity ratios are the ideal indicator of liquidity of banks operating in
developed financial markets, the ratios do not reveal the intrinsic liquidity profile of Indian
banks which are operating generally in an illiquid market. Experiences show that assets
commonly considered as liquid like Government securities, other money market
instruments, etc. have limited liquidity as the market and players are unidirectional.
Thus, analysis of liquidity involves tracking of cash flow mismatches.
For measuring and managing net funding requirements, the use of maturity ladder and
calculation of cumulative surplus or deficit of funds at selected maturity dates is
recommended as a standard tool. The format prescribed by RBI in this regard under
ALM System is adopted for measuring cash flow mismatches at different time bands.
The cash flows should be placed in different time bands based on future behavior of
assets, liabilities and off-balance sheet items i.e. banks should have to analyze the
behavioral maturity profile of various components of on / off-balance sheet items on the
basis of assumptions and trend analysis supported by time series analysis.
The difference between cash inflows and outflows in each time period, the excess or
deficit of funds becomes a starting point for a measure of a banks future liquidity surplus
or deficit, at a series of points of time. The banks should also consider putting in place
certain prudential limits to avoid liquidity crisis:
1. Cap on inter-bank borrowings, especially call borrowings
2. Purchased funds vis--vis liquid assets;
3. Core deposits vis--vis Core Assets i.e. Cash Reserve Ratio, Liquidity Reserve Ratio
and Loans;
4. Duration of liabilities and investment portfolio;
5. Maximum Cumulative Outflows: Banks should fix cumulative mismatches across all
time bands;
6. Commitment Ratio tracking the total commitments given to corporate/banks and
other financial institutions to limit the off-balance sheet exposure;
7. Swapped Funds Ratio, i.e. extent of Indian Rupees raised out of foreign currency
sources.

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The analysis of net funding requirements involves the construction of a maturity ladder i.e.
comparison of future cash inflows to outflows over a series of specified time periods.

Whether a bank has sufficient liquidity also depends on the cash flow behavior under
alternative scenarios like,
a) General market conditions (going concern scenario),
b) Bank specific crisis,
c) General market crisis.
ll. Managing market access i.e. building strong relationships with
individual as well as organizational funding sources has direct contribution
to enhancing a banks liquidity.
lll. Contingency planning Banks should prepare Contingency Plans to
measure their ability to withstand bank-specific or market crisis scenario. The
blue-print for asset sales, market access, capacity to restructure the maturity
and composition of assets and liabilities should be clearly documented and
alternative options of funding in the event of banks failure to raise liquidity
from existing source/s could be clearly articulated. Availability of back-up
liquidity support in the form of committed lines of credit, reciprocal
arrangements, liquidity support from other external sources, liquidity of
assets, etc. should also be clearly established.

7.5 CASE STUDY ON DYNAMIC LIQUIDITY:


For a better understanding of Dynamic Liquidity analysis, let us take a hypothetical case
study of ABC Bank as under:
ABC Bank has its books loans and advances of Rs 25000 crores as on 31-12-2007.
During the last two years it has achieved growth in advances to the extent of 10% and
11% respectively. The Bank has now sanctioned high value loans to the extent of Rs 250
crores disbursement of which is expected to take place in next 90 days. Based on the
past trend and thrust for the new business, the bank is hopeful to achieve net increase in
loans to the extent of Rs 1050 crores in the next 90 days. However, loan repayments are
estimated at Rs 100 crores during the period.
ABC Bank has got deposits of Rs 45000 crores as on 31-12-2007. About 45% of these
deposits are payable on demand. Growth in deposits during the past two years was
around 8%. The Bank expects some of the large deposits amounting to around Rs 250
crores falling due in the next two months not to be rolled over because of better avenues
available to these depositors. The Bank on a conservative basis expects deposit growth
to be around 6% in view of past trend and stiff competition from some of the private
banks, which have got technological superiority. Based on a budgetary review on growth
of deposits, the bank expects growth in deposits of around Rs 650 crores in next 3
months. After taking into account CRR requirements of 4.74% required at present to be

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maintained with RBI, net increase in deposits available for deployment is about Rs 619
crores.
ABC Bank desires to participate in bidding of Government securities to the minimum
amount of Rs 400 crores in view of better yield considerations compared with available
securities and also considering that these securities have only sovereign risk.
Redemptions of existing investments falling due in next three months are Rs 125 crores.
The net increase in investments is thus estimated at around Rs 275 crores.
Bank has cash and balances lying with RBI and other banks to the extent of Rs 50
crores which can be withdrawn immediately. Bank has undrawn export refinance facility
of Rs60 crores available with RBI.
For the purpose of simplicity, we may measure that there are no major changes in cash
flow on account of other assets, other liquidities and off-balance sheet items. The data
furnished above result in Dynamic liquidity analysis as follows:
(Amount Rupees in Crores)
OUTFLOWS

1-90 Days

Net increase in loans and advances

950

Net increase in investments


(Treasury bills, Dated Government securities, bonds, debentures, shares,
mutual funds)

275

Total Outflows

1225

INFLOWS
Net Cash Gain

50

Net increase in Deposits (less CRR obligations)

619

Refinance eligibility (export credit)

60

Total Inflows

729

Mismatch (Inflows Outflows)

(-) 496

Mismatch as % of total outflows

(-) 40.48%

Table V: Dynamic Liquidity Structure of ABC bank


From the given data and analysis, it could be concluded as under:
Dynamic liquidity analysis shoes negative mismatch of Rs 496 crores in next 90
days period. The negative mismatch is 40.48% of outflows and is considered at a
high level-necessitating bank to look for alternative sources to bridge the gap and
overcome the liquidity strain.

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While the Bank has acted aggressively in growth of loan portfolio and wishes to
take advantage of investment opportunities, deposit growth is not sufficient to
fund asset growth. In a situation like this, when the bank would like to take on the
available business opportunities from profitable considerations, it is likely to face
liquidity problem unless adequate funds are tied up.
One option available with the Bank is to resort to borrowing which will have cost
implications. Borrowing of this magnitude can be resorted only if the management
is reasonably assured that liquidity problem is of temporary nature and there is a
basis to expect substantial accretion in the near future.
As the bank has witnessed a slow down in deposit growth in the last two years
presumably under the competition of other technology savvy banks, in needs to
examine its capabilities to ensure adequate growth in deposits. Various strategies
need to be charted out foe accretion of deposits. If the Bank feels that the growth
in deposits be modest in coming years, it needs to put certain restrictions on
growth of loan portfolio before it is caught in a liquidity problem.
The data and analysis carried over in the Dynamic Liquidity Model help bank
management to ponder over various issues regarding how to position balance
sheet of the bank with the view to capture all business opportunities while at the
same time remaining liquid.
Dynamic liquidity analysis will be a useful tool provided adequate data is collected
on future business trends of major clientele, economic environment of the area in
which the bank is predominantly operating and level of competition.

7.6 STRUCTURAL LIQUIDITY STATEMENT (STL):


It is the statement produced under the guidelines of RBI showing the various items of
inflow and outflow as well as their variations in the various maturity buckets. Following
the RBI guidelines the items are placed in various maturity buckets and the gaps and
cumulative gaps are calculated to find out whether they remain within the prudential
limits prescribed by RBI. Deviations from the prudential limits need to be monitored to
avoid adverse effects of various risks. It has to be provided by Indian banks to the RBI
on a fortnightly basis. The STL statement as per the guidelines of RBI is provided in
annexure I.

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ANAGEMENT OF INTEREST

RATE RISK

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Interest rate risk means changes in the interest income due to changes in the rate
of interest which will ultimately affect the value of banks assets, liabilities and offbalance sheet instruments.
A fall in interest rate may adversely affect the interest income from advances. But
deposits will have to be carried at higher cost till their maturity if they have already been
mobilized for long-term tenure on fixed interest basis.
Let us try to understand the effect of interest rate risk from the point of view of a common
man, Mr. A considering his following assets and liabilities:
Particulars
Rate of Interest
Assets
Savings Bank A/c
3.5%
5 yrs Fixed Deposit
9.5%
5 yrs NSE
9%
Current A/c
0%
Liabilities
Housing Loan-15 yrs(repayable)
12.5%
Vehicle Loan-7 yrs
9%
Consumer Loan-4 yrs
13.5%
Now let us assume that due to ------ the housing loan rate increased by 2% to 14.5%, the
vehicle loan rate increased by 2.5% to 11.5% the
consumer loan rate increased by 3% to 16.5%
So, we can find that as the interest rate of liabilities has increased, the assets of
Mr. A cannot match the liabilities in the changed scenario. So he will have to manage his
assets in such a way so that he can deal with this problem of mismatch.
The scenario is just the opposite in case of banks whose assets are the loans, advances
while the savings A/c and current A/c etc. are the liabilities. So the mentioned changes in
interest rates will produce completely opposite results for the banks.

Table VI: Expected Balance Sheet for Hypothetical Bank


(Rs in crores)
Assets
Yield
Liabilities
Rate sensitive
500
8.0%
600
Fixed Rate
350
11.0%
220
Non earning
150
100
920
Equity
80
Total
1000
1000

Cost
4.0%
6.0%

NII = (0.08*500 + 0.11*350) - (0.04*600 + 0.06*220)


= Rs.78.5 cr Rs. 37.2 cr = Rs. 41.30 cr
NIM = 41.3/850 = 4.86%
GAP = 500 600 =-100

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Table VII: 1% Increase in Short-Term Rates: Expected Balance Sheet for


Hypothetical Bank

Rate sensitive
Fixed Rate
Non earning

Assets
500
350
150

Equity
Total

1000

Yield
9.0%
11.0%

Liabilities
600
220
100
920
80
1000

Cost
5.0%
6.0%

NII = (0.09*500 + 0.11*350) - (0.05*600 + 0.06*220)


= 83.5 43.2 = 40.3%
NIM = 40.3/850 = 4.74%
GAP = 500 600 =-100

Table VIII: 1% Decrease in Short-Term Rates: Expected Balance Sheet


for Hypothetical Bank

Rate sensitive
Fixed Rate
Non earning
Equity
Total

Assets
500
350
150

Yield
8.5%
11.0%

1000

Liabilities
600
220
100
920
80
1000

Cost
5.5%
6.0%

NII = (0.085*500 + 0.11*350) - (0.055*600 + 0.06*220)


= 81 46.2 = 34.8%
NIM = 34.8/850 = 4.09%
GAP = 500 600 =-100

Table IX: Proportionate Doubling in Size: Expected Balance Sheet for


Hypothetical Bank

Rate sensitive
Fixed Rate
Non earning
Equity
Total

4
7

Assets
1000
700
300

2000

Yield
8.0%
11.0%

Liabilities
1200
440
200
1840
160
2000

Cost
4.0%
6.0%

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NII = (0.08*1000 + 0.11*700) - (0.04*1200 + 0.06*440)


= 157 74.4 = 82.6%
NIM = 82.6/1700 = 4.86%
GAP = 1000 1200 =-200

Table X: Increase in RSAs and Decrease in RSLs: Expected Balance


Sheet for Hypothetical Bank

Rate sensitive
Fixed Rate
Non earning
Equity
Total

Assets
540
310
150

Yield
8.0%
11.0%

1000

Liabilities
560
260
80
900
100
1000

Cost
4.0%
6.0%

NII = (0.08*540 + 0.11*310) - (0.04*560 + 0.06*260)


= 77.3 38 = 39.3%
NIM = 39.3/850 = 4.62%
GAP = 540 560 =-20
8.1 TYPES OF INTEREST RATE RISK

8.1.1 Mis-match Risk: It is the risk arising from the mismatch in the repricing
maturities of interest rate sensitive assets and liabilities. For e.g. a deposit contracted
for a five year term repricable every six months has a repricing maturity of six months.
Such items of assets and liabilities which will be priced / repriced based on the
interest rates prevailing at the time of issue / repricing are called interest rate
sensitive assets / liabilities.e.g. deposits, borrowings, loans, investments etc. On the
other hand, premises, computers, stationery etc. are non-sensitive to changes in
interest rates in the market.
Gap between the interest sensitive liabilities and assets on any day or during a
specified time bucket is the measure of the mis-match risk on that day or the time
period as the case may be. If more interest rate sensitive assets reprice / mature on
a day on a day or over a time interval (time bucket) than interest rate sensitive
liabilities during the same period, the gap is called a Positive Gap and if more
liabilities reprice than assets during the period such gaps are called Negative Gap.
The following statement illustrates this concept:

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(Rs in crores)

Assets/Liability items

Assets
Cash
Deposits with banks
Investments
Loans
Premises
Total
Liabilities
& net
worth
Current Deposits
Savings Deposits
Term Deposits
Borrowings
Other Liabilities
Net worth
Total
Interest
rate
sensitive
gap
(repricable assets
repricable liabilities)

1-28
days

20
180
1200

29
days 3mnths

100
300

1400

400

600
800
100
400

200
100
300
200

1900
-500

800
-400

>3mnths6mnths

80
320
400

>6mnths1yr

100
400
500

>1yr

Nonsensitive

Totals

20

20
20
960
2820
600
4420

500
600
1100

600
620

20
500

500
-100

200

200

200
+300

100
700
820
+900 -200

820
900
1300
700
700
4420

Cumulative gap
-500 -900
-1000
-700
+200
Table XI: Mis-match Risk arising from the mismatch in the repricing maturities of
interest rate sensitive assets and liabilities.
The impact of changing interest rates on the repricing assets and liabilities and in turn
the, the combined impact on NII can be analyzed from the above statement. For
instance, during the first time bucket liabilities to the extent of Rs 500 cr are repricing
over and above the assets repricing during the bucket. The downside for the banks NII
is that if interest rates rise during the period banks NII will be squeezed, as liabilities to
the tune of Rs 500 crore will reprice at higher interest rates for the remaining period of
the performance horizon of 1 year.
Again, in the fourth time bucket assets to the tune of Rs 300 cr reprice in excess of
liabilities which reprice during the same time bucket. Here banks NII will be adversely
impacted if there is going to be a fall in interest rate during the time of pricing.
Thus, the relationship between interest rate changes and their impact on net interest
income is as follows:

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Gap
Interest Rate Change
Impact on NII
Positive*
Increases
Positive
Positive
Decreases
Negative
Negative
Increases
Negative
Negative
Decreases
Positive
*Note: RSA-Rate Sensitive Assets & RSL-Rate Sensitive Liabilities. Positive Gap
is where RSA is more than RSL and Negative Gap is vice versa.
Table XII: Relation between Gap, Interest rate change and Impact in NII

8.1.2 Basis Risk: is the risk arising from the differing impact of a given change in
any of
the bench mark interest rates on the interest rates in various segments such as
treasury bills, call money, repo etc.In other words, the risk of change in interest
rate of an asset and the corresponding liability in different magnitude is called
Basis Risk.
Let us take the following e.g.
XYZ Bank Ltd.
Liabilities

Assets

Call Money
Repo
Deposits
Total

50 Treasury Bills
50 Advances
100
200 Total

150

Negative gap

50

30
120

Table XIIIa: Interest sensitive gap position 1- 30 days bucket


If interest rate increases by 1%, bank will lose 0.5 crore per year assuming that the rise
in interest will be uniformly applicable to all the items of assets and liabilities. But in real
world the interest rates on assets and liabilities do not change in the same proportions.
For instance, call may go up by 1%, Repo by 0.5%, deposits by 0.25%, treasury bills by
1.0%and advances by 0.75%.
Call
Repo
Deposits

50
50
100

0.01
0.005
0.0025

Treasury Bills
Advances

30
120

0.01
0.0075

Net impact on NII


Table XIIb: Net Impact on NII under changed scenario

50

0.5
0.25
0.25
1
0.3
0.9
1.2
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8.1.3 Yield curve risk: On account of volatility in interest rates, the yield curve
unpredictably and often substantially, changes in shape. If the interest rates on
assets and liabilities are pegged to the bench mark rates (like treasury bills cut-off
rates), there is the risk that the interest spread may decrease as term spread
narrows down.
Let us assume that a bank has raised a floating rate deposit which will be repriced
1% above the 91 days Treasury Bills (TB) cut-off and invested the amount in a
floating rate loan of the same repricing interval but at a spread of 2% above 364 days
Treasury Bills cut-off. The following table shows the Yield Curve Risk involved, as the
spread between the two maturities of Treasury Bills narrowed.
Period

91 days TB

364 days TB

Term Spread

Interest spread
between
deposits
and
loans

April 2008

8.75%

10.07%

1.32%

2.32%

June 2008

9.24%

10.32%

1.08%

2.08%

August 2008

9.46%

10.28%

.82%

1.82%

March 2009

9.16%

9.93%

0.77%

1.77%

Table XIV: Yield curve risk involved as the spread between two maturities of Treasury
Bills narrowed
8.1.3. Embedded option risk: When a liability or asset is contracted
with a call
option for the customer, it involves an embedded option risk. Banks provide
an option to depositors to prematurely close the deposits and to borrowers
to prepay the advances. Now depositors may prematurely close the
deposits when interest rate increase and redeposit at higher rates and when
interest rates decline borrowers may opt to prepay the loans and renew the
same at lower rate. In both the cases banks NII is adversely affected.

8.1.4. Reinvestment risk: When a bank gets back the repayment of a


loan
before the payment of the corresponding liability is due for payment, the
rate at which such cash flow can be invested is uncertain and such risk is
called Reinvestment Risk.
8.1.5. Price Risk: The decline in the market price of a security due to rise in
the
market interest rate is called the Price Risk. The values of investments
change inversely to interest rates. Thus if interest rates in the market
increase, investments suffer depreciation and if interest rates decline

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investments in the banks portfolio gain in value. The price changes in


investments are on account of the present values of cash flows in the bond
being altered when discounted by the new interest rate.

8.2 EFFECTS OF INTEREST RATE RISK


Changes in interest rates can have adverse effects both on a bank's earnings and its
economic value. This has given rise to two separate, but complementary, perspectives
for assessing a bank's interest rate risk exposure.
8.2.1 Earnings perspective: In the earnings perspective, the focus of analysis
is the impact of changes in interest rates on accrual or reported earnings.
This is the traditional approach to interest rate risk assessment taken by
many banks. Variation in earnings is an important focal point for interest
rate risk analysis because reduced earnings or outright losses can
threaten the financial stability of an institution by undermining its capital
adequacy and by reducing market confidence.

.
8.2.2 Economic value perspective : Variation in market interest rates can also
affect the economic value of a bank's assets, liabilities and off balance
sheet positions. Thus, the sensitivity of a bank's economic value to
fluctuations in interest rates is a particularly important consideration of
shareholders, management and supervisors alike. The economic value of
an instrument represents an assessment of the present value of its
expected net cash flows, discounted to reflect market rates.

8.3

INTEREST RATE RISK MANAGEMENT TECHNIQUES

8.3.1 Repricing Schedule: This method distributes interest-sensitive


assets,
liabilities and off balance sheet positions into a certain number of predefined
time bands according to their maturity (if fixed rate) or time remaining to their
next repricing (if floating rate). Those assets and liabilities lacking definitive
repricing intervals (e.g. sight deposits or savings accounts) or actual
maturities that could vary from contractual maturities (e.g. mortgages with an
option for early repayment) are assigned to repricing time bands according to
the judgment and past experience of the bank.
8.3.2 Gap Analysis: In Gap Analysis process, to evaluate earnings
exposure,
interest rate sensitive liabilities in each time band are subtracted from the
corresponding interest rate sensitive assets to produce a repricing "gap" for
that time band. This gap can then be multiplied by an assumed change in
interest rates to yield an approximation of the change in net interest income
that would result from such an interest rate movement. The size of the
interest rate movement used in the analysis can be based on a variety of

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factors, including historical experience, simulation of potential future interest


rate movements and the judgment of bank management.
8.3.3 Duration: Duration is a measure of the percent change in the economic
value of a position that will occur given a small change in the level of interest
rates. It reflects the timing and size of cash flows that occur before the
instrument's contractual maturity. Generally, the longer the maturity or next
repricing date of the instrument and the smaller the payments that occur
before maturity (e.g. coupon payments).

8.3.4. Simulation Approaches: Simulation techniques typically involve


detailed
assessments of the potential effects of changes in interest rates on earnings
and economic value by simulating the future path of interest rates and their
impact on cash flows.
Simulations can be static or dynamic.
In static simulations, the cash flows arising solely from the bank's current on- and offbalance sheet positions are assessed. For assessing the exposure of earnings,
simulations estimating the cash flows and resulting earnings streams over a specific
period are conducted based on one or more assumed interest rate scenarios. Typically,
although not always, these simulations entail relatively straightforward shifts or tilts of the
yield curve or changes of spreads between different interest rates. When the resulting
cash flows are simulated over the entire expected lives of the bank's holdings and
discounted back to their present values, an estimate of the change in the bank's
economic value can be calculated.
In a dynamic simulation approach, the simulation builds in more detailed assumptions
about the future course of interest rates and the expected changes in a bank's business
activity over that time. Such simulations use these assumptions about future activities
and reinvestment strategies to project expected cash flows and estimate dynamic
earnings and economic value outcomes. These techniques allow for dynamic interaction
of payments stream and interest rates, and better capture the effect of embedded or
explicit option.

8.4 SOUND INTEREST RATE RISK MANAGEMENT PRACTISES


Sound interest rate risk management involves the application of four basic elements in
the management of assets, liabilities and off-balance-sheet instruments:
Appropriate board and senior management oversight;
Adequate risk management policies and procedures;
Appropriate risk measurement, monitoring and control functions; and
Comprehensive internal controls and independent audits.

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RATE RISK OF FOREIGN EXCHANGE

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The risk inherent in running open foreign exchange positions have been heightened in
recent years by the pronounced volatility in forex rates, thereby adding a new dimension
to the risk profile of banks balance sheets. Foreign exchange rate risk is the risk that
a bank may suffer losses as a result of adverse exchange rate movements during
a period in which it has an open position, either spot or forward, or a combination
of the two, in an individual foreign currency.
In the forex business, banks also face the risk of default of the counterparties or
settlement risk. While such type of risk crystallization does not cause principal loss,
banks may have to undertake fresh transactions in the cash/spot market for replacing
the failed transactions. Thus, banks may incur replacement cost, which depends upon
the currency rate movements. Banks also face another risk called time-zone risk or
Herstatt risk which arises out of time-lags in settlement of one currency in one centre
and the settlement of another currency in another time zone.
The forex transactions with counterparties from another country also trigger sovereign or
country risk.

Fig III: Impact of Hedging on Expected Cash Flows of the Firm

9.1 TYPES OF EXCHANGE RISK


Foreign exchange exposure can be broadly classified into 3 categories depending upon
the nature of exposure:
Transaction exposure

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Translation exposure
Operating exposure

9.1.1 Transaction exposure


It measures the risk involved due to change in the foreign exchange rate between the
time, the transaction is executed and the time it is settled.
Few foreign exchange transactions which may expose banks to transaction exposure
are:
Purchase and sale of goods and services in foreign currency.
Loan repayments to be made in foreign currency.
Dividends paid or received in foreign currency.

9.1.2 Translation exposure


It relates to valuation of foreign currency assets and liabilities at the end of accounting
year at current realizable values at the end of accounting year. These losses/gains are
also known as accounting losses /gains as they are notional and no real cash flows are
involved. It involves greater significance for banks with branches operating in other
countries and in different currencies.

9.1.3 Operating exposure


It is a measure of sensitivity of future cash flows and profits of a bank to unanticipated
exchange rate changes.

Figure IV: Conceptual Comparison of Differences among Operating, Transaction, and


Translation Foreign Exchange Exposure

9.2 TOOLS AND TECHNIQUES FOR MANAGING FOREIGN


EXCHANGE RISK
Some of the various tools, available for hedging of foreign exchange risk are:
A. Forward Contracts
B. Futures
C. Options

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D. Swaps

Forward Contracts
It is an agreement to buy or sell foreign exchange for a pre-determined amount, at a
predetermined rate and on a predetermined date; it involves cash flow on the date of
delivery and not at the time of entering the contract.
Futures
Futures are forward contracts with standardized maturity date (1-6 months) governed by
a set of guidelines stipulated by exchange concerned for settlements and payments.
These are thus useful to hedge or convert known currency or interest rate exposures.
Options
It is a contract of future delivery of a currency in exchange for another, where the holder
of the option has the right, without any obligation, to buy or sell the currency at an
agreed price, the strike or exercise price, on a specified future date, but is not required to
do so.
Call option is the right to buy
Put option is the right to sell.
American options permit the holder to exercise at any time before the expiration date
Swaps
It is a financial transaction in which two counter parties agree to exchange streams of
payments, or cash flows, over time, on the basis agreed at the inception of such
arrangement.
Currency swap involves two parties agreeing to exchange specific amounts of
two different currencies at the outset and to repay this overtime in installments,
reflecting interest and principal.
Interest rate swap involves periodical exchange of interest payment streams of
different characters. There are two main types:
Coupon swaps: Fixed rates to floating rates.
Basis swaps: Exchange of one benchmark for another under floating
rates.
Sometime currency and interest rate swaps are done together.

9 .3 STEPS IN FOREX RISK MANAGEMENT


Benchmarking: Given the exposures and the risk estimates, the bank has to set its limits
for handling foreign exchange exposure. The bank also has to decide whether to manage its
exposures on a cost centre or profit centre basis. A cost centre approach is a defensive one
and the main aim is ensure that cash flows of a firm are not adversely affected beyond a
point. A profit centre approach on the other hand is a more aggressive approach where the
firm decides to generate a net profit on its exposure over time.

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Hedging: Based on the limits a bank set for itself to manage exposure, the firms then
decides an appropriate hedging strategy. As discussed earlier, there are various financial
instruments available for the firm to choose from: futures, forwards, options and swaps
and issue of foreign debt.
Stop Loss: The banks risk management decisions are based on forecasts which are
but estimates of reasonably unpredictable trends. It is imperative to have stop loss
arrangements in order to rescue the bank if the forecasts turn out wrong. For this, there
should be certain monitoring systems in place to detect critical levels in the foreign
exchange rates for appropriate measure to be taken.
Reporting and Review: Risk management policies are typically subjected to review
based on periodic reporting. The reports mainly include profit/ loss status on open
contracts after marking to market, the actual exchange/ interest rate achieved on each
exposure and profitability vis--vis the benchmark and the expected changes in overall
exposure due to forecasted exchange/ interest rate movements. The review analyses
whether the benchmarks set are valid.

Forecasts

Risk

Estimation

FRAMEWORK FOR RISK


MANAGEMENT

Benchmarking

Hedging

Stop Loss

Reporting and Review

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Fig V: Framework for Foreign Exchange Risk Management

9.4 STRATEGIES FOR FOREIGN EXCHANGE MANAGEMENT


There are a number of alternative strategies that can be employed when managing
foreign exchange risk:
a) Do nothing - undertake currency transactions as they arise.
b) Hedge known future obligations - this is the strategy that by default smaller Corporate
uses.
c) Use the time between the recognition of the foreign exchange exposure and the time
that the foreign currency will be needed, to achieve the lowest price of the foreign
currency. This can normally be most effectively achieved by a predetermined strategy
that sets levels and trigger points to achieve purchasing targets.
Both strategy (a) and (b) are commonly used as they are the easiest. They require no
additional decision-making, they are administratively simple, and they have been the
status quo for so long that some market participants aren't even aware those
alternatives are available.
However these two strategies have serious flaws the first is that they can carry a very
high level of risk to the cash flows of the company. The reason that the risks are so high
with these strategies is that they are extreme positions. To hedge every exposure means
removing any chance that the market may move beneficially for the company, whilst its
competitors may still enjoy the benefits of these price movements, in doing so the cash
flows are at risk as competitors may lower selling prices and hence the profit margin is
reduced because of diminished revenues as a direct result of hedging. To not cover any
foreign exchange exposures leaves the company equally vulnerable to adverse
movements in the exchange rate that could result in cost blowouts, and since cost
increases are equally as harmful to margins as revenue decreases they also have
explosive potential to undermine the profitability of the whole company.

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FUND TRANSFER PRICING


Many international banks having different products and operate in various geographic
markets have been using internal Funds Transfer Pricing (FTP). FTP is an internal
measurement designed to assess the financial impact of uses and sources of
funds and can be used to evaluate the profitability. It can also be used to isolate
returns for various risks assumed in the intermediation process. FTP also helps correctly
identify the cost of opportunity value of funds.
FTP envisages assignment of specific assets and liabilities to various functional units
(profit centers) lending, investment, deposit taking and funds management. Each unit
attracts sources and uses of funds. The lending, investment and deposit taking profit
centers sell their liabilities to and buys funds for financing their assets from the funds
management profit centre at appropriate transfer prices. The transfer prices are fixed on
the basis of a single curve (MIBOR or derived cash curve, etc) so that asset-liability
transactions of identical attributes are assigned identical transfer prices. Transfer prices
could, however, vary according to maturity, purpose, terms and other attributes.
The FTP provides for allocation of margin (franchise and credit spreads) to profit centers
on original transfer rates and any residual spread (mismatch spread) is credited to the
funds management profit centre. This spread is the result of accumulated mismatches.
The margins of various profit centers are:

Deposit profit centre:


Transfer Price (TP) on deposits - cost of deposits deposit insurance- overheads.
Lending profit centre:
Loan yields + TP on deposits TP on loan financing cost of deposits deposit
insurance - overheads loan loss provisions.
Investment profit centre:
Security yields + TP on deposits TP on security financing cost of deposits deposit
insurance - overheads provisions for depreciation in investments and loan loss.
Funds Management profit centre:
TP on funds lent TP on funds borrowed Statutory Reserves cost overheads.
For illustration, let us assume that a banks Deposit profit centre has raised a 3 month
deposit @ 6.5% p.a. and that the alternative funding cost i.e. MIBOR for 3 months and
one year @ 8% and 10.5% p.a., respectively. Let us also assume that the banks Loan
profit centre created a one year loan @ 13.5% p.a. The franchise (liability), credit and
mismatch spreads of bank is as under:

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Profit Centers
Deposit

Funds

Loan

Total

Interest Income

8.0

10.5

13.5

13.5

Interest Expenditure
Margin

6.5
1.5

8.0
2.5

10.5
3.0

6.5
7.0

Loan Loss Provision (expected) -

1.0

1.0

Deposit Insurance
Reserve Cost (CRR/ SLR)
Overheads

0.1
0.6

1.0
0.5

0.6

0.1
1.0
1.7

NII

0.8

1.0

1.4

3.2

Table XV: Funds management profit centre The liability, spread and mismatch spreads
of a bank
Under the FTP mechanism, the profit centers (other than funds management) are
precluded from assuming any funding mismatches and thereby exposing them to market
risk.
The credit or counterparty and price risks are, however, managed by these profit
centers. The entire market risks, i.e. interest rate, liquidity and forex are assumed by the
funds management profit centre.
The FTP allows lending and deposit raising profit centers determine their expenses and
price their products competitively. Lending profit centre which knows the carrying cost of
the loans needs to focus on to price only the spread necessary to compensate the
perceived credit risk and operating expenses. Thus, FTP system could effectively be
used as a way to centralize the banks overall market risk at one place and would
support an effective ALM modeling system. FTP also could be used to enhance
corporate communication; greater line management control and solid base for rewarding
line management.

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VALUE AT RISK (VaR) aND DURaTION


BaSED aLM
11.1 DEFINITION
Value at risk or VaR is a maximum potential loss at a specified confidence level
and specified horizon under normal market situation.
For example, if a portfolio of stocks has a one-day 5% VaR of Rs 1 million, there is a 5%
probability that the portfolio will fall in value by more than Rs 1 million over a one day
period, assuming markets are normal and there is no trading. Informally, a loss which
exceeds the VaR threshold is termed as VaR break.

11.2 THE IDEA BEHIND VaR


The most popular and traditional measure of risk is volatility.
For investors, risk is about the odds of losing money, and VaR is based on that commonsense fact. By assuming investors care about the odds of a really big loss, VaR answers
the question, "What is my worst-case scenario?" or "How much could I lose in a really
bad month?"
A VaR statistic has three components: a time period, a confidence level and a loss
amount (or loss percentage).

11.3 METHODS OF CALCULATING VaR


Institutional investors use VaR to evaluate portfolio risk, but in this introduction we will
use it to evaluate the risk of a single index that trades like a stock: the Nasdaq 100
Index, which trades under the ticker QQQQ. The QQQQ is a very popular index of the
largest non-financial stocks that trade on the Nasdaq exchange. There are three
methods of calculating VAR: the historical method, the variance-covariance method and
the Monte Carlo simulation.

11.3.1. Historical Method


The historical method simply re-organizes actual historical returns, putting them in order
from worst to best. It then assumes that history will repeat itself, from a risk perspective.

11.3.2. The Variance-Covariance Method


This method assumes that stock returns are normally distributed. In other words, it
requires estimation of two factors - an expected (or average) return and a standard
deviation - which allow to plot a normal distribution curve.

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11.3.3. Monte Carlo Simulation


The third method involves developing a model for future stock price returns and running
multiple hypothetical trials through the model. A Monte Carlo simulation refers to any
method that randomly generates trials, but by itself does not tell anything about the
underlying methodology.

11.4. USES OF VaR

Measure of trading portfolio (Market) Risk extended to Credit and Operational


Risks.
Provision of capital for Business Units, to cover sudden losses.
Limit Setting and Monitoring (Mid-office): If a trader loses more than e.g. 15% of
capital (as per VaR) allocated to him, he should stop trading.
Risk Adjusted Performance Measurement: If profits in both lines (e.g. bonds &
FX) = Rs. 10, but VaR B= Rs. 20 and VaR FX= Rs. 30, then Risk Adjusted Return
On Capital greater for bonds.

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IT and related software enable to build an integrated approach which combines liability
models with that of asset allocation decisions have proved desirable and more efficient
in that it can lead to better ALM decisions.

12.1 A TYPICAL ALM SYSTEM


A typical ALM system consists of the following modules:

Administration

The administration module lets the administrator conduct various user activities as well
as some distinct functions. The administrator can add a new user, modify or delete an
existing user or lock / unlock a user. Various categories linked with a group of users can
be set. This module sets up user-level permissions to access different options from the
ALM system, depending on the category of the user.

Registration
This module handles registration of the bank and its branches into the ALM system.
Before extracting data from any branch, it is necessary to register the branch. The bank /
branch ID and address are also updated in the database during registration.

Rule guide
The rule guide is one of the most important modules in the system. Only the
administrator has privileges to access this module for setting the various parameters of
the ALM system. Data processing can be carried out only after all the required
parameters have been set.
The various functions performed by the module are:
Enable / disable account heads: The user can enable or disable asset or
liability account heads in the system.
Account head maintenance: The user can add, modify or delete account
heads with the help of this function.
Percentage settings: Percentages can be defined to identify the 'bucket' for
all those account heads that are of a percentage type (for example, 30 per cent
in the first bucket, 50 per cent in the second bucket and 20 per cent in the third
bucket).
Bucket codes maintenance: The user can set various buckets for various
reports. In case the buckets defined by the RBI for SLP, IRS, MAP or SIR
changes, this function can be used.

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Settings of account heads to appear in a report: The user can select the
account heads which should appear in a report, with the help of this function.
i.
RBI code mapping: This function lets the user map ALM account codes with
the RBI account codes
ii.
Client code mapping: This function lets the user map ALM account codes with
the client account codes.
iii.
Data process: This module allows the user to upload the data into the system
manually or through a flat file for:
Trial balance
Residual accounts
Parameterized accounts
Bucket-wise accounts
The user can set the 'as on date' and copy the data for one particular branch from the
previous 'as on date' to the next 'as on date' with the help of this module.

Consolidation
This has two sub-modules; pre-consolidation and consolidation. The pre-consolidation
sub-module consolidates the balances of all the account heads branch-wise and puts
them into appropriate time buckets, whereas the consolidation sub-module consolidates
the data from all the branches and computes the figures at bank level into various time
buckets reports:
Structural liquidity profile (SLP)
Interest rate sensitivity (IRS)
Maturity and position (MAP)
Statement of interest rate sensitivity (SIR)

Data analysis
Data analysis projects the balance of any account head for any future date by three
different methods linear, polynomial and exponential provided the historical data for
two, three or more previous 'as on dates' is available with the system. The projected
balances could be of any account head or any time bucket of an account head for the
structural liquidity profile report. This is also known as forecasting. Data analysis also
does simulations, with which an amount pertaining to any time bucket for any account
can be altered and placed in a different time bucket, to see the overall impact on the
structural liquidity and interest rate reports. This makes it much easier for the
management to take decisions.

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Strengths
The ALM system works on most easily available software and hardware platform
User-defined account heads
Generation of statutory returns
System is capable of handling modules such as:
Data analysis
Data forecasting
Interest rate simulation
With new breakthroughs in technology, researchers tried to apply their findings in ways
that are useful to institutional and private investors. In fact, some interesting softwares
were created to cater the need of this niche market. In this section, some of them will be
discussed.
First of all, there is PROFITstar, which is an asset-liability management, budgeting and
simulation application that can help in decision-making for institutions. It uses an
integrated, strategic approach to managing financial goals and the position of
institutions. Some of the other interesting features are that it helps to avoid inaccuracies
that can result from relying solely on contractual maturity roll-off.
Moreover, PROFITstar Interest Rate Sensitivity (IRSA) Matrix is able to simulate eight
distinct rate swings and analyze their effects on income, capital and other key ratios.
The software provider Surya is one that has developed products such as
MitiGet (a market risk control system) and
Balm (a bank asset liability management system).
The following are some of the features of MitiGet:
Tracks portfolio by exposure, stand-alone performance and relative performance.
Tracks MTM and period returns.
Has comprehensive cash flow definition module, modeling all dimensions of cash
flow as random variables.
Facilitates analysis of position, return and market risk on multiple and flexible
dimensions such as industry, region, credit rating, market cap and liquidity.
Facilitates dynamic grouping.
Supports risk policy definition in terms of limits on both positions and value at
risk.
Supports two limits - soft and hard limits.
Supports hierarchical and across the board concentration groups for limit
definitions.

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Sensitivity and Scenario Analysis.


Considering Balm, it facilitates measurements of:
1) Structural liquidity, and
2) Interest rate sensitivity.
The liquidity module features of Balm are:
Ability to compare cash flow mismatches across maturity spectrum,
Can set tolerance limit for mismatch,
The highlighting of maturity buckets that are under stress,
The comparison of cash flow mismatches against tolerance
limit. Following are the features of the interest rate sensitivity module:
It segregates assets and liabilities into interest rate sensitive and non-interest rate
sensitive categories. Further, interest rate sensitive assets and liabilities are
sliced and distributed across seven maturity buckets.
Maturity buckets that have mismatch between rate sensitive assets and rate
sensitive liabilities are highlighted.
Identifies components of assets and liabilities that contribute to mismatch in a
given maturity bucket. This enables the user to initiate corrective action.
Users can generate several interest rate scenarios across maturity buckets and
evaluate their impact on Net Interest Income (NII).

Some other well known vendors are TCS, Oracle, and HCL etc.
In case of UCO bank, about 50% of the branches are under CBS which covers 85% of
the business while the rest 50% branches account for 15% of the banking business. The
Data Centre is nodal point which is responsible for data from the CBS branches while
the MIS team collects data from the non-CBS branches and then these two data are
merged to create the STL statement that has to be provided to the RBI on a fortnightly
basis. This data is also used in ALCO meetings held to primarily assess the liquidity
situation, whether gap exists, whether the gap is within the prescribed prudential limit
and whether the existing gap is beneficial or not. If the gap is not beneficial then reasons
behind it and the probable solutions are discussed by ALCO.

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DATA COLLECTION
Maturity pattern of certain items of Assets and Liabilities only is published in the Banks
Annual Report. As other data is not made available to public, an approximation has been
made based on the actual Data of the bank to reflect a hypothetical Asset Liability profile
of UCO Bank, based on which the Project Study has been built up.

13.1 ALM: CASE STUDY OF A BANK

Microsoft Office
Excel 2003 Workshee

In order to collect data for the case study, the hypothetical data of a bank is developed.
To attain this objective as well as to deal with a realistic scenario, the annual reports of
CO bank are studied and accordingly a close approximation is developed.
Let us name the bank as Lord Mahaveer Bank whose Structural Liquidity Statement
(STL) of the bank is obtained by approximation and adjustment of the data of UCO
bank..

13.2 DATA ANALYSIS


Analysis of the STL in the normal scenario:
In the normal scenario, we find that the cumulative mismatch as percentage of
cumulative outflows ratios are well within the prudential limits provided by RBI and that
the bank is dealing with short-term assets(in the maturity buckets from 1-28days) and
long-term liabilities(in the maturity buckets from29 days-above 5 years). There lies a
negligible gap between the maturity of the assets and liabilities within the prudential
limits.
We can see that the bank is not deploying the funds according to maturity profile
of the liability. This may be due to:
Bank is presuming an increase in the interest rate and so is holding its funds in
the short term to deploy when the rate rises. When the rate goes up there will be
increase in NII.Then more of banks assets will reprice at a higher rate than
liabilities and therefore, revenue will increase more than the cost of borrowed
funds. But considering the present economic condition, there is a scarce chance
that rates will rise considerably, may be it can increase by a quarter basis points.
But if the trend continues without any change in the interest rate then there will be
decrease in NII.

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Bank is following a conservative approach i.e. to hold funds rather than deploy it
so that it does not bear the risk to be a defaulter of payment.
Bank is bearing this opportunity loss to maintain its image in the market.
Bank probably has less number of borrowing lines available in the market and
thus it cannot rely on emergency borrowing from the market and is maintaining a
cushion from its long term liabilities to meet the emergencies rather than resorting
to market borrowing.

Options available to the bank:


The bank has a comfortable liquidity position in the long term but it should improve on its
asset position in the long term by suitable deployment of funds so that opportunity loss is
minimized and NII is improved.
Funds can be deployed in three ways which are discussed below in order of preference:
1. Equity: Deploying funds in equity market is a comparably safe option since
at present the sensex is recovering and bank will enjoy quick returns and
capital gain.
2. Loans: In this case, the bank is exposed to credit risk considering chances
of default of payment. Thus, though the yield is attractive in case of loans,
in case of default, the bank has to bear the cost of capital.
3. Investments: There are two choices available in case of investments:
Investments in floating rate bonds: Here the risk is minimized as the
floating rate bonds can be hedged. Two situations can be there:

If the interest rate rises then the bank should not do


anything as it is receiving float and paying fixed.

If the interest rate falls, then the bank can hedge to IRS and
receive fixed and pay float.

Investments under Government securities: This is the least


preferable option. Here also two situations can arise:
If the interest rate rises, the bank may receive float and pay
fixed.
If the interest rate falls, then the bank may do nothing and
continue to receive fixed and pay float.

Considering the reverse situation, in the normal scenario we get

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Statement of
structural liquidity
under normal
scenario
Cumulative
mismatch as % to
cumulative outflows
Prudential limits

Day 1

-287.43%
-5.00%

2-7 Days

-94.03%
-10.00%

8-14
Days
-83.37%
-15.00%

15-28
Days
-38.51%
-20.00%

29 Days
& upto 3
Months
9.34%
-30.00%

2009

Over 3
months &
upto 6
Months
8.09%

Over 6
Months &
upto 1 Yr

Over 3 Yr
& upto 3
Yrs

20.71%

17.82%

-30.00%

-35.00%

-30.00%

Over 3
Yrs &
upto 5
Yrs
8.15%

Above 5
Yrs

-15.00%

-10.00%

It is found that the bank has leveraged short term liabilities with long term assets and
has strain in its immediate liquidity position. The bank has bridged the prudential limits
and is a completely outlier facing serious liquidity risk problems.
The options available to the bank are:
1. Bank may liquidate its assets i.e. loans and investments taking into account
the cost involved.
2. Bank may sell its investments even at loss considering the situation.
3. Bank may go for securitizations i.e. sell its loan portfolio.
4. Bank may tap known resources at very attractive rates for borrowing for 1 or 3
years or 3-6 months period.

FINDINGS AND RECOMMENDATIONS


Following the assumptions of RBI for crisis scenario, the STL for market specific crisis
and bank specific crisis conditions are developed.

14.1 LIQUIDITY UNDER CRISIS SCENARIO


A. Estimation of liquidity under Banks Specific Crisis Scenario
Estimating liquidity under Banks Specific Crisis Scenario would involve recasting of
Structural Liquidity Statement as provided below:

Assumptions by regulator:
1. Substituting 15% of total outstanding advances as NPA and in place of NPA
included in structural liquidity statement
2. Reworking the term loan repayment schedule by assuming a 5% restructuring
of outstanding term loans and deferment of repayment by one year. The same
would apply on repayment obligation of other constituents excluding counter
parties
3. Non renewal of bulk deposits that are falling due over next three months

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Analysis of the STL under bank specific crisis scenario:


In this case the situation is quite grave with negative cumulative mismatch percentages
which are beyond the prudential limits in all but the last 3 maturity buckets. The bank has
more RSLs than RSAs in all the buckets. The bank will be benefitted if the interest rate
decreases. Mostly the mismatch percentages deviated from prudential limits in the first 3
buckets, the highest being in the first bucket with liabilities much exceeding the assets.

Options available to the bank:


1. The bank may try to create funds by emergency borrowing for 1-2 months at a
slightly higher rate than the prevailing market rate of interest.
2. Bank may raise the interest rate suitably over and above the competitors to
attract short term depositors. The bank can introduce some tailor-made products
(For example- Fixed Deposit Schemes @ 8% for a lock-in period of 100-150
days, etc).
3. Liquidity Adjustment Facility: RBI can act as the last resort of the bankers through
liquidity adjustment facilities like reverse repo, etc.
4. Back Stop Facility: RBI may provide the bank with the liquidity support at the
bank rate under Collateralized Lending Facility (CLF) which is available to each
scheduled bank at a level of 0.125% of its average aggregate deposits.
5. Export Reference Facility: RBI provides refinance facilities to the extent of 15%
against eligible exports. These refinance facilities are presently provided up to
50% as normal refinance and remaining 50% as back stop facility while normal
refinance facility is at Bank Rate, back stop facility is at variable rate. Bank may
utilize these refinance facilities to tide over temporary liquidity need.
6. The bank may avoid taking additional commitment.
7. The bank may dispose its long-term investment, judicially at a minimum cost.
8. The bank may sell its loan portfolio to other banks to raise funds.
9. The bank may try to borrow from some of its clients with whom they enjoy good
relations.
10. The bank may use relationship with correspondent banks for short term
requirements subject to prudential limits of 25% of Tier I capital.

14.2. ESTIMATION OF LIQUIDITY UNDER MARKET CRISIS


SCENARIO
Estimating liquidity under Market Crisis Scenario would involve recasting of Structural
Liquidity Statement as provided below:

Assumptions by regulator:
1. 10% reduction in investment portfolio may be incorporated to account for the
market crisis arising out of drying up of liquidity in the market.
2. Non renewal of bulk deposits that are falling due over next three months.

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Analysis of the STL under market specific crisis scenario:


Though there are negative mismatch percentages beyond the prudential limits, the
situation is not as grave as the bank specific crisis situation.

Options available to the bank:


The assumptions are severe in bank-specific crisis than in market-specific
crisis, as the latter is universal it requires RBIs active intervention. The prudential limits
which are valid for normal market situation may be under pressure under sustained
illiquid and credit crisis scenario. Under these circumstances,
1. The bank can approach RBI for liquidity.
2. The RBI may tweak the CRR and or SLR as it happened during the Dec08
Qr to infuse liquid funds /liquidity into the system.
3. RBI can increase refinance facility.

CONCLUSION
The study undertaken in course of the project not only introduced asset liability
management but also revealed various sensitive aspects related directly and indirectly to
the subject. Overall successful functioning of asset liability management begins with
proper co-ordination and collection of data from the branch levels (CBS as well as non
CBS) throughout India. This is followed by mapping the data as per guidelines and
analyzing the data. Analysis of data also includes scenario analysis in order to
apprehend and avoid serious asset liability problems. Subsequently, solutions to such
problems or indications to the same are developed. The decisions taken are formulated
into action plans to be followed thereafter, along with abidance by the prevailing policies
and procedures for the overall smooth running of the bank.
The aspect of scenario analysis, in a simplified form is taken up for the case study
whereby in the normal situation it is found that the bank is in dealing with short term
assets and long term liabilities and the various probable reasons to this are discussed.
Further, the options available in this regard are sited. When the regulators assumptions
for bank specific crisis are loaded on the normal scenario the situation turned out to be
grave requiring emergency funding. But considering the normal scenario, this could not
be relied upon as the sole option available and thus other probable course of action are
discussed. However, the market specific crisis was less serious when compared to the
bank specific one owing to the general assumptions of the regulator.

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Thus, it is found that the bank exercises an overall conservative approach which, if made
more flexible to an extent, will help the bank better cope with either crisis situations or
mere fluctuations in the market.

CONSTRAINTS AND LIMITATIONS


1. The main constraint prevails in form of sensitive data and its collection. Limited
data is provided in public domain which was an impediment. Thus, an organized
study considering previous years data in its entirety could not be achieved and a
hypothetical data based on approximation, has been made.
2. The time period was also a constraint considering the vastness and details
involved in the subject.
3. The technical nature of the study has helped to gather practical knowledge to a
large extent but the conclusion drawn is based on researchers limited knowledge
in this subject.

SCOPE FOR FURTHER STUDY


The study opens up scope for further research on
Hedging mechanism and the selection of suitable strategies.
Pricing an asset or a liability product with a view to bridge the gaps.
Scenario analysis and back testing of the outcome with the actual.

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Annexure I
Name of the Bank:
Statement of Structural Liquidity as on:
(Amount in crores of Rupees)
Residual Maturity Profile
OUTFLOWS

1
Day

2-7
Days

8-14
Days

15-28
Days

29
Days
up to 3
month
s

Over 3
months
and up
to
6
months

Over 6
months
and up
to
1
Year

Over 1
year
and up
to 3
years

Over 3
years
and up
to 5
years

Over
5
years

Total

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

1. Capital
2. Reserves
and Surplus
3. Deposits
(a)Current
Deposits
(b)Savings

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Bank Deposits
(c)Term
Deposits
(d)
Certificates
Deposit

of

4.Borrowings

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

5.
Other XXX
Liabilities
&
Provisions

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

(a)Call
and
Short Notice
(b)InterBank (Term)
(c)
Refinances
(d)
Others
(Specify)

(a)
Payable

Bills

(b)
Provisions
(c) Others
6. Lines
of XXX
Credit
committed to
(a) Institutions
(b)
Customers

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7.
Unavailed
portion of Cash
Credit /
Overdraft /
Demand Loan
component of
Working
Capital

8. Letters of
Credit
/
Guarantees
9. Repos
10.
Bills
Rediscounted
(DUPN)
11.
Swaps
(Buy / Sell) /
maturing
forwards

12.
Interest
payable
13.
Others
(Specify)
A.
TOTAL
OUTFLOWS
B.
CUMULATIVE
OUTFLOWS
(Amount in crores of Rupees)
Residual Maturity Profile

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INFLOWS

1
Day

2-7
Days

8-14
Days

15-28
Days

29
Days
up to 3
months

Over 3
months
and up
to 6
months

Over 6
months
and up
to 1 Year

Over 1
year
and up
to 3
years

Over 3
years
and up
to 5
years

Over
5
years

Total

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

1. Cash

2. Balances
with RBI
3. Balances
with other
Banks
(a)Current
Account
(b)Money at
Call and Short
Notice, term
Deposits and
other
placements
4. Investments
(including
those under
Repos but
excluding
Reverse
Repos)
5. Advances
(Performing)
(a) Bills
Purchased and
Discounted
(including bills

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under DUPN)

(b) Cash
Credit,
Overdrafts and
Loans
repayable on
demand
(c) Term
Loans
6. NPAs
(Advances and
Investment)*
7. Fixed Assets

8. Other
Assets

XXX XXX

XXX XXX

XXX

XXX

XXX

XXX

XXX

XXX XXX

(a)Leased
Assets

(b)Others

9. Reverse
Repos

10. Swaps
(Sell / Buy) /
Maturing
Forwards
11. Bills
Rediscounted
(DUPN)
12. Interest
payable
13. Committed
Lines of Credit

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14. Export
Refinance from
RBI
15. Others
(Specify)
C. TOTAL
INFLOWS

D. MISMATCH
(C-A)
E. MISMATCH
as % to
OUTFLOWS
(D as % to A)

F.
CUMULATIVE
MISMATCH
G.
CUMULATIVE
MISMATCH as
a % to
CUMULATIVE
OUTFLOWS
(F as a % to
B)

Net of provisions, interest suspense and claims receivable from ECGC / DICG

Annex II
Guidance for slotting the future cash flows of banks in the revised time buckets
Heads of Accounts
Outflows
1. Capital, Reserve and surplus
2. Demand Deposits (Current and
Savings Deposit )

81

Classification into time buckets


Over 5 years time bucket
Savings Bank and Current Deposits may

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be classified into volatile and core portions.


Savings Bank (10%) and Current (15%)
Deposits are generally withdrawable on
demand. This portion may be treated as
volatile. While volatile portion can be
placed in the Day 1, 2-7 days and 8-14
days time buckets, depending upon the
experience and estimates of banks and the
core portion may be placed in over 1- 3
years bucket.
The above classification of Savings Bank
and Current Deposits is only a benchmark.
Banks which is better equipped to estimate
the behavioural pattern, roll-in and roll-out,
embedded options, etc. on the basis of
past data/empirical studies could classify
them in the appropriate buckets, i.e.
behavioural
maturity
instead
of
contractual maturity, subject to the
approval of the Board/ALCO.
3. Term Deposits

Respective maturity buckets. Banks which


are better equipped to estimate the
behavioural pattern, roll-in and roll-out,
embedded options, etc. on the basis of
past data/empirical studies could classify
the retail deposits in the appropriate
buckets on the basis of behavioural
maturity rather than residual maturity.
However, the wholesale deposits should
be shown under respective maturity
buckets. (wholesale deposits
for
the
purpose of this statement may be Rs 15
lakhs or any such higher threshold
approved by the banks Board).

4. Certificate of Deposits

Respective maturity buckets.


Where
call/put options are built into the issue
structure of any instrument/s, the call/put
date/s should be reckoned as the maturity
date/s and the amount should be shown in
the respective time buckets.

5. Other Liabilities and provisions


(i)Bills Payable

(i) The core component which could


reasonably be estimated on the basis of
past data and behavioural pattern may be
shown under Over 1-3 years time bucket.
The balance amount may be placed in Day
1, 2-7 days and 8-14 days buckets, as per

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(ii) Provisions other than for loan loss and


depreciation in investments
(iii) Other Liabilities

Heads of Accounts
Inflows
1. Cash
2. Balances with RBI

3. Balances with other Banks


(i)Current Account

(ii) Money at Call and Short Notice, Term


Deposits and other placements
4. Investments
(i)Approved securities

(ii) Corporate debentures and bonds, PSU


bonds, CDs and CPs, Redeemable
preference shares,
Units of Mutual Funds (close ended), etc
(iii)Shares
(iv)Units of Mutual Funds (open ended)
(v) Investments in Subsidiaries/ Joint
Ventures
(vi) Securities in the Trading Book

5. Advances ( Performing )

behavioural pattern.
(ii) Respective buckets depending on the
purpose.
(iii) Respective maturity buckets. Items not
representing cash payables (i.e. income
received in advance, etc.) may be placed
in over 5 years bucket.

Classification into time buckets


Day 1 bucket
While the excess balance over the
required CRR/SLR may be shown under
Day 1 bucket, the Statutory Balances may
be distributed amongst various time
buckets corresponding to the maturity
profile of DTL with a time-lag of 14 days.
(i) Non-withdrawable portion on account of
stipulations of minimum balances may be
shown under Over 1-3 years bucket and
the remaining balances may be shown
under Day 1 bucket.
(ii) Respective maturity buckets.

(i) Respective maturity buckets, excluding


the amount required to be reinvested to
maintain SLR corresponding to the DTL
profile in various time buckets.
(ii)
Respective
maturity
buckets.
Investments classified as NPIs should be
shown under over 3-5 years bucket (substandard) or over 5 years bucket
(doubtful).
(iii) Listed shares (except strategic
investments) in 2-7days bucket, with a
haircut of 50%. Other shares in Over 5
years bucket
(iv) Day 1 bucket
(v) Over 5 years bucket.
(vi) Day 1, 2-7 days, 8-14 days, 15-28
days and 29-90 days according to
defeasance periods.
Provisions may be netted from the gross

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investments provided provisions are held


security-wise. Otherwise provisions should
be shown in over 5 years bucket.
6. Non-Performing Assets
7. Other Assets

8. Lines of Credit committed /


available
(i) Lines of Credit committed to/ from
Institutions
(ii) Unavailed portion of Cash Credit/
Overdraft / Demand loan component of
Working Capital limits (outflow)

(iii) Export Refinance Unavailed (inflow)

Sub-standard assets may be shown over


3-5 years bucket and Doubtful and Loss
Assets to be shown over 5 years bucket.
Intangible assets Intangible assets and
assets not representing cash receivables
may be shown in Over 5 years bucket.

(i) Day 1 bucket.


(ii) Banks should undertake a study of the
behavioural and seasonal pattern of
potential availments in the accounts and
the amounts so arrived at may be shown
under relevant maturity buckets up to 12
months
(iii) Day 1 bucket.

BIBLIOGRAPHY
1. Risk Management Policy & Asset Liability Management Policy 2006-07, UCO
Bank
2. RBI Circular on Asset Liability Management System in Banks issued in February,
1999
3. Guidance Note on Market Risk Management issued by RBI in October 2002.
4. www.wikipedia.com, free encyclopedia- Asset Liability Management, VaR, VaR
Models.
5. www.forexriskmngmnt.com

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6. www.rbi.com
7. www.fedai.com
8. www.riskglossary.com
9. www.riskbook.com
10. www.investopedia.com
11. Risk Management and Financial Derivatives by Satyajit Das, McGraw Hill
12. Basel II Integrated Risk Management Solution
13. Bank for International Settlement, Asset Liability Management
14. Bank Management by Hempel, Simonson and Coleman
15. Bank Management by SinkeyRediff News- Why is Risk Management important?,
by Nupur Hetamsaria
16. Risk Management by Indian Institute of Banking & Finance, Macmillian

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