Académique Documents
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OF FINANCIAL INSTITUTIONS
14 July 2005
BANGLADESH BANK
Focus Group Members
Asset Liability Management
Team
Sudhir Chandra Das DGM Bangladesh Bank
Co-ordinator
Arif Khan GM IDLC of Bangladesh Ltd.
Asad Khan MD (Designate) Fareast Finance & Investment Ltd.
Head of Finance & National Housing Finance and
Jadab Malakar
Company Secretary Investments Ltd.
Team Members SVP & Company International Leasing and
Nehal Ahmed
Secretary Financial Services Ltd.
Head of Finance &
Delta Brac Housing Finance
S. H. Aslam Habib Resources and Company
Corporation Ltd.
Secretary
Tapan K. Podder MD Prime Finance & Investment Ltd.
Asset Liability Management
Executive Summary iv
Appendix
Executive Summary
Asset Liability Management is the most important aspect for the Financial Institutions to manage
Balance Sheet Risk, especially for managing of liquidity risk and interest rate risk. Failure to identify
the risks associated with business and failure to take timely measures in giving a sense of direction
threatens the very existence of the institution. It is, therefore, imperative for the Financial
Institutions to form “Asset Liability Management Committee (ALCO)” with the senior
management as its members to control and better manage its Balance Sheet Risk.
The main responsibilities of ALCO are to look after the Financial Market activities, manage liquidity
and interest rate risk, understand the market position and competition etc. In carrying out its
responsibilities, the ALCO needs to convene periodical meeting and should regularly review the
decisions of the meeting with due consideration of the market situation.
The report aims at promoting international best practices in Balance Sheet Risk Management for the
Financial Institutions in Bangladesh. The purpose of this paper is to provide guidance to
management and to train new staffs. This is intended to be the basic framework for further
development of skill and to introduce new policies and processes as we make progress in
understanding and implementing the basics.
iv
1.0 Introduction
1.1 Background
Every Financial Institute irrespective of its size is generally exposed to market liquidity and interest
rate risks in connection with the process of Asset Liability Management. Failure to identify the risks
associated with business and failure to take timely measures in giving a sense of direction threatens
the very existence of the institution. It is, therefore, important that the strategic decision makers of an
organization assume special care with regard to the Balance Sheet Risk management and should
ensure that the structure of the institute’s business and the level of Balance Sheet risk it assumes are
effectively managed, appropriate policies and procedures are established to control the direction of
the organization. The whole exercise is with the objective of limiting these risks against the resources
that are available for evaluating and controlling liquidity and interest rate risk.
1.2 Objectives
1.3 Scope
This paper will address the possible risks associated with the normal course of business of a financial
institute and suggest the best possible ways to minimize risks. Taking into consideration the nascent
state of the Financial Institution’s, familiarization of the key elements in the ALM would help the
institutions to gradually induct the guidelines, systematically improve the management practices and
in due course upgrade their internal controls. This paper at best may be viewed as a guideline, a tool
for management upgradation rather than a mandatory compliance on the part of the financial
institutions.
1.4 Methodology
The general methodology of the work includes analyzing already followed practices of the Financial
Institutions of South East Asia and local Financial Institutions to manage Balance Sheet Risk.
Practices followed by Banks to the extent it matches with the activities of Financial Institutions have
also been analyzed. Different reports, Bangladesh Bank Guidelines, web site information of different
financial institutions were used as primary input for this paper.
1.5 Limitations
Since this is the first study on the aspect of Asset Liability Management of Financial Institutions in
Bangladesh, the exact risk quantification process is still under trial and error. In the absence of
information about Market risk, the evaluation of risk of each Financial Institute corresponding to the
market could not be quantified at this stage. Risks of the respective financial institutions would be
unique to their own environmental conditions and the institutions would be the best judge of their
remedial actions required for corrective actions.
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2.0 Balance Sheet Risk Profile
In carrying out the business, every Financial Institution has to encounter several risks like, liquidity,
interest rate, prepayment, credit, reinvestment and event risk etc. Among them, liquidity risk is
associated with the Financial Institutes’ ability to meet its financial commitment and obligation,
interest rate risk is associated with both funding and lending activities, prepayment risk is associated
with early repayment of loans, credit risk is associated with default due to client’s failure to repay
loan installment, reinvestment risk is associated with reinvestment of prepayment/regular repayment
proceeds at less than the existing rate and event risk is associated with happening of an unforeseen
event that may cause financial loss to the organization.
Assets serve as a source of liquidity and must be framed in groups according to the nature of either
“available for sale” or “held to maturity”. Status of liquidity is to be judged in terms of length of
time it takes to dispose off the asset and the price the asset carries when it is sold. The following
points are to be considered at the time of asset structuring:
a) Nature of business.
b) Tenure of lending.
c) Interest rate structure - fixed or floating.
d) Pattern of repayment – regular installment or bullet payment.
e) CRR and SLR requirement.
Every organization meets its funding needs through liability management. Liability structuring must
be made in such a way so that it matches with the tenure of asset structure. The following points are
to be considered at the time of liability structuring:
a) Grouping of liability into two major categories according to the maturity namely, long term
and short term.
b) Pricing option.
c) Exchange rate fluctuation in case of foreign currency transactions.
d) Early repayment option.
Capital structure includes Equity, Preference share, long term Bond under both clean and
securitization arrangement etc. The following points are to be considered at the time of capital
structuring:
a) Regulatory framework.
b) Favorable gearing ratio.
c) Capital adequacy ratio.
d) Value of the organization.
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2.2 Interest Rate Risk
Interest rate risk affects spread from lending business. Interest rate risk arises due to change in
overall market interest rate structure both on borrowing and lending.
Interest on borrowing has a significant bearing on the pricing of lending. It affects profitability of an
organization and desired margin to the shareholders.
Interest rate risk arises due to reduction of interest rate on lending from time to time on several
occasions. The Company has to reduce interest rate on several occasions to attract more clients and
to compete with the competitors.
Prepayment risk arises due to early repayment either partial or entire loan portfolio, which result in
loss of interest income.
Default risk arises due to client’s failure to repay loan installment in due time. Default risk analysis
help identify the reason of default, customer group of making default in respect of their profession
and income status. Default risk is quantified in terms of loan being classified as SS, DF, and BL etc.
Credit spread risk arises due to non-recovery of regular installment repayment, which ultimately
decreases the overall effective lending rate and erodes margin from lending business. Credit spread
risk also arises due to stringent Income Recognition policy in respect of framing time for SS, DF,
and BL.
The risk that the amount of prepaid loans will be reinvested at less than the existing rate is
reinvestment risk. Declining interest rate environment induces borrower to make prepayment and
forces Financial Institutions to invest at comparatively lower rate.
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2.6 Event Risk
Financial Institutions are prone to event risks, a few examples are as under:
1) Restriction regarding participation on money market transactions and accepting short-term
customer deposit.
2) Introduction of VAT on the service charge of Lease and Housing Finance business.
3) Disallowing loan loss provision.
4) Highest Corporate tax bracket.
Operation
Fund Requirement Implem-
Treasury ALCO Meeting entation
Finance & Feed-
back
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4.0 Policy Statement
Management Committee of the Financial Institutions should set out the following policy statement
and an annual review should be made taking into consideration of the changes in the Balance Sheet
and market dynamics:
The Loan to Fund Ratio = Loan & Lease Finance/ (Capital + Reserve + Deposit + Bank Borrowing+
Bond + Other)
The Loan to Fund ratio should not exceed 95%. Any excess lending must be supported by confirmed
sources of fund. However, it must be borne in mind that under extreme liquidity crisis in the money
market, even under arranged credit lines, lenders may express their inability to disbursed funds.
The cashflow statement should be framed in such a way so that it gives information to management
for GAP analysis. Cashflow statement should be made for different maturity period viz., within 7
days, 2 weeks, 1-12 months, above 1 year – 3 years, above 3 years – 5 years, above 5 years - 10
years, above 10 years to 15 years, above 15 years - 20 years. etc., as per the situation demands.
Maturity wise Interest Rate Profile should be made both for lending and borrowing products so that
Management can know its effective lending and borrowing rate at any particular point in time. This
would help make Spread Analysis.
Management should classify its assets and liabilities according to their maturity tenure viz., within 7
days, 2 weeks, 1-12 months, above 1 year – 3 years, above 3 years – 5 years, above 5 years - 10
years, above 10 years to 15 years, above 15 years - 20 years. etc., as per the situation demands.
4.6 Compliance
Internal as well as statutory compliances must be strictly followed. Keeping the market scenario and
regulatory framework, the internal compliance procedure should be flexible enough to adopt any
required change immediately to meet the changing situation.
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5.0 Balance Sheet Risk Management Process
Information is the key to the ALM process. ALM information system should be designed in such a
way so that it could provide reliable information on time to the ALCO. An organization should have
clear risk policies and definite tolerance limits. Risk can be measured using different methods, which
ranges from the simple Gap Statement to extremely sophisticated and data intensive Risk Adjusted
Profitability Measurement methods. The Treasury Department with the help of IT Department
should develop Modules, which could provide information on the aspects of liquidity and interest
rate regime.
The success of ALM depends on organization policies, information system, well-defined delegation-
responsibility process, accountability of team member, reporting to the Management etc. The ALCO
should have overall responsibility for management of risks and should decide the risk management
policy of the Company and set limits for liquidity, interest rate, exchange rate and equity pricing
risks.
The ALM Support Groups consisting of operating staff should be responsible for analyzing,
monitoring and reporting the risk profiles to the ALCO. In due course of time the staff should also
prepare forecasts reflecting the impact of various possible changes in market conditions on the
balance sheet and recommend the action needed to adhere to internal limit.
ALM process involves management of both liquidity risk and interest rate risk. These are explained
below:
Measuring and managing liquidity needs are vital for effective operation of the Company. By
assuring the Company’s ability to meet its liabilities as they become due, liquidity management can
reduce the probability of an adverse situation. The importance of liquidity transcends individual
institutions, as liquidity shortfall in one institution can have repercussions on the entire system. The
ALCO should measure not only the liquidity positions of the Company on an ongoing basis but also
examine how liquidity requirements are likely to evolve under different assumptions. Experience
shows that assets commonly considered to be liquid, such as govt. securities and other money market
instruments, could also become illiquid when the market and players are unidirectional. Therefore,
liquidity has to be tracked through maturity or cash flow mismatches. For measuring and managing
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net funding requirement, the use of a maturity ladder and calculation of cumulative surplus or deficit
of funds at selected maturity dates is adopted as a standard tool. The format of the statement of
liquidity is attached in Appendix I.
(b)Time Buckets
The Maturity Profile, as detailed in Appendix I, could be used for measuring the future cashflows of
a financial institute in different time buckets. The time buckets shall be distributed as under:
Every financial institute is required to maintain a Cash Reserve Ratio (CRR) of 2.50% on its
customer deposits. The CRR is maintained with the non-interest bearing current account with the
Bangladesh Bank. In addition, every financial institute is required to maintain a Statutory Liquidity
reserve (SLR) of 5% (including CRR) on all its liabilities. There is no restriction on where these SLR
will be maintained. The financial institutions holding deposits are given freedom to place the
mandatory securities in any time buckets as suitable for them. These SLRs shall be kept with banks
and financial institutions for different maturities.
Within each time bucket, there could be mismatches depending on cash inflows and outflows. While
the mismatches up to one year would be relevant since these provide early warning signals of
impending liquidity problems, the main focus should be on the short-term mismatches viz., 1-90
days. The cumulative mismatches (running total) across all time buckets shall be monitored in
accordance with internal prudential limits set by ALCO from time to time. The mismatches (negative
gap) during 1-90 days, in normal course, should not exceed 15% of the cash outflows in this time
buckets. If the Company, in view of current asset-liability profile and the consequential structure
mismatches, needs higher tolerance level, it could operate with higher limit sanctioned by ALCO
giving specific reasons on the need for such higher limit.
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(e) Statement of Structural Liquidity
The statement of Structural Liquidity (Annexure I) shall be prepared by placing all cash inflows and
outflows in the maturity ladder according to the expected timing of cashflows. A maturing liability
will be a cash outflow while a maturing asset will be a cash inflow. While determining the likely
cash inflow/outflow, every financial institute has to make a number of assumptions according to its
asset-liability profiles. While determining the tolerance levels, the Company should take into account
all relevant factors based on its asset-liability base, nature of business, future strategies, etc. The
ALCO must ensure that the tolerance levels are determined keeping all necessary factors in view and
further refined with experience gained in Liquidity Management.
In order to enable the Company to monitor its short-term liquidity on a dynamic basis over a time
horizon spanning from 1 day to 6 months, ALCO should estimate short-term liquidity profiles on the
basis of business projections and other commitments for planning purposes. An indicative format
(Annexure II) for estimating short-term Dynamic liquidity is enclosed. The format should be
reviewed and revised over time based on the future requirements.
The Gap is the difference between Rate Sensitive Assets (RSA) and Rate Sensitive Liabilities (RSL)
(Appendix II) for each time bucket. The positive gap indicates that it has more RSAs than RSLs
whereas the negative Gap indicates that it has more RSLs. The GAP reports indicate whether the
institute is in a position to benefit from rising interest rates by having a positive Gap (RSA>RSL) or
whether it is in a position to benefit from declining interest rates by a negative Gap (RSL>RSA). The
Gap can, therefore, be used as a measure of interest rate sensitivity.
The Treasury Department should set prudential limits on individual Gaps in various time buckets
with the approval of the ALCO. Such prudential limits should have a relationship with the Total
Assets, Earning Assets or Equity. In addition to the interest rate gap limits, the Treasury Department
may set the prudential limits in terms of Earnings at Risk (EaR) or Net interest margin based on their
views on interest rate movements with the approval of the ALCO.
The Gap Report should be generated by grouping rate sensitive liabilities, assets and off-balance
sheet positions (Annexure III) into time buckets according to residual maturity or next re-pricing
period, whichever is earlier. All investments, advances, deposits, borrowings, purchased funds, etc.
that mature/re-price within a specified time-frame are interest rate sensitive. Similarly, any principal
repayment of loan is also rate sensitive if the Company expects to receive it within the time horizon.
This includes final principal repayment and interim installments. Certain assets and liabilities carry
floating rates of interest that vary with a reference rate and hence, these items get re-priced at pre-
determined intervals. Such assets and liabilities are rate sensitive at the time of re-pricing. While the
Page 8
interest rates on term deposits are generally fixed during their currency, the tranches of advances are
basically floating. The interest rates on advances could be re-priced any number of occasions,
corresponding to the changes in PLR (Performing Loan Ratio).
The interest rate gaps may be identified in the following time buckets:
The various items of rate sensitive assets and liabilities and off-balance sheet items shall be classified
into various time-buckets.
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6.0 Conclusion and Recommendation
Every financial institute must have a committee comprising of the senior management to make
important decisions related to the Balance Sheet Risk management process. The committee should
meet at least once in every month to analyze, review and formulate strategy to manage the Balance
Sheet Risk.
In every ALCO meeting, the key points of the discussion should be minuted and the action points
should be highlighted to better position the Balance Sheet. In every ALCO meeting, action points
taken in the past ALCO meeting should be reviewed to ensure implementation. The ALCO takes
decisions for implementation of any/all of the following issues:
i) Need for Deposit mobilization or Asset growth in right buckets to minimize asset-liability
mismatch.
ii) Both short and long term Cashflow plan should be based on market interest rates & liquidity.
iii) Need for change in Fund Transfer Pricing and /or customer rates in line with strategy
adapted.
iv) Address to the limits that are in breach (if any) or are in line of breach and provide detailed
plan to bring all limits under control.
v) Address to all regulatory issues that are under threat to non-compliance.
vi) Call special ALCO meeting when any contingency situation arises.
6.2 Feedback
All ALCO members are provided with the minutes of the meeting within the next day. The main
points of consideration are as under:
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APPENDIX I
1. Capital funds
(a) Equity capital, Non-redeemable or perpetual In the 'over 5 years' time bucket
preference capital, Reserves, Funds and Surplus
(b) Preference capital – redeemable/non perpetual As per the residual maturity of the shares.
3. Deposits:
(a) Term deposit from public As per the residual maturity
(b) Term deposits from Banks/FIs These, being institutional/wholesale deposits,
should be slotted as per their residual maturity
4. BORROWINGS:
(a) Term money borrowings As per the residual maturity
(b) Bank borrowings (SOD) Over six months and up to one year
(b) Expenses Payable (other than interest) As per the likely time of cash outflow.
(c) Advance income received In the 'over 5 years' Time-bucket as these do not
involve any cash outflow.
(d) Interest payable on bonds/deposits In respective lime buckets as per the due date of
payment.
(e) Provision for NPAs The amount of provision may be netted out from the
gross amount of the NPA portfolio and the net
amount of NPAs belated time-buckets
(f) Provision for Investments portfolio The amount may be netted from the gross value of
investments portfolio and the net investments be
shown as inflow in the prescribed lime-slots. In
case provisions are not held security-wise, the
provision may be shown on “over 5 yrs” time slot.
B. INFLOWS
1.Cash In 1 to 30/31 day time-bucket.
(a) Any event-specific cash flows (e.g. outflow due to wage settlement arrears, capital expenses, income-
tax refunds, etc.) should be shown in a time bucket corresponding to timing of such cash flows.
(b) Overdue receivables on account of interest and installments of standard loans/hire purchase
assets/leased rentals should be slotted as below:
(i) Overdue for less than one month. In the 3 to 6 month bucket
(ii) Interest overdue for more than one month but In the 6 to 12 month bucket without
less than seven months
(i e) before the relative amount becomes past reckoning the grace period of month
D. FINANCING OF GAPS:
The negative gap (i.e. where outflows exceed inflows) in the 1 to 30/31 days time-bucket should not exceed
the prudential limit of 15% of outflows of each time-bucket and the cumulative gap up to the one-year period
should not exceed 15% of the cumulative cash outflows upto one year period. In case these limits are
exceeded, the measures proposed for bringing the gaps within the limit, should be shown by a footnote in the
relative statement.
APPENDIX II
(b) Fixed rate (plain vanilla) including zero Sensitive; reprice on maturity of such
coupons instruments.
(c) Instruments with embedded options Sensitive; could reprice on the exercise date of
the option particularly in rising interest rate
scenario. To be placed in respective time buckets
as per the next exercise date.
3. Deposits:
(a) Deposits/Borrowings As per the residual maturity
4. Borrowings
(a) Term Loan borrowings Sensitive; reprices on maturity. To be placed as
per residual maturity in the relative time bucket.
4. Investments
(a) Fixed income securities (e.g. govt. securities zero Sensitive on maturity. To be slotted as per
coupon bends, bonds, debentures, cumulative non- residual maturity.
cumulative, redeemable preference shares etc,)
8. Other assets
Intangible assets and items not representing Non –sensitive
cash inflows.
ANNEXURE I
(Amount in crore)
A. Outflows 1 to Over Over 2 Over 3 Over6 Over
one months months months one Over 3
30/31 Over 5
years to Total
day (one month to 3 to 6 to one year to years
to 2 5 years
month) months months year 3 years
months
1. Capital
(a) Equity and perpetual preference shares
4. Deposits
(a) Term deposits from public
(b) Term deposits from Banks/FIs
5. Bank Borrowings
(a) SOD
(b) Long term loans
6. Current Liabilities and provisions :
(a) Short term loans
(b) Accounts payable
(c) Advance income received
(d) Interest payable on bonds/ deposits
(e) Provisions
7.Contingent Liabilities
(a) Letters of credit/guarantees
(b) Loan commitments, pending disbursal
(c) Lines of credit committed to other institutions
8. Others
A. TOTAL OUTFLOWS (A)
B. INFLOWS
1.Cash
2. Remittance in transit
3. Balances with banks
(a) Current account
(b) Deposit/ short-term deposits
(c) Money at call & short notice
4. Investments (net of provisions)
5. Lease Finance & Loans (performing)
(a) Lease finance
(b) Home Loans
(c) Term loan
(d) Corporate loans/short term loans
6. Non-performing loans
7. Fixed assets (excluding assets on lease)
8. Other assets :
(a) Intangible assets & other non-cash flow items
(Taka in crore)
1 -14 15-28 29 days 3 - 6
days days to 3 m o n t h s
Outflows months
1. Increase in loans & Advances
2. Net increase in investments
(i) Govt. /approved securities
(ii) Bonds/debentures/shares
(iii) Others
3. Net decrease in public deposit
4. Net decrease in borrowings from various sources/net increase in market
lending
5. Outflow on account of off-balance sheet items
6. Other outflows
TOTAL OUTFLOWS (A)
INFLOWS
1. Net cash position
2. Net increase in deposits
3. Interest inflow on investments
4. Interest inflow on performing Advances
5. Net increase in borrowings from various sources
6. Inflow on account of off-balance sheet items
7, Other inflows
TOTAL INFLOWS (B)
C. MISMATCH (B-A)
D. CUMULATIVE MISMATCH
E. C AS PERCENTAGE TO TOTAL OUTFLOWS
ANNEXURE III