Asset Liability Management in Banks

Asset liability management in banks
Sr. No.
Particulars
Page No.
1.
Introduction
2.
Earlier Phase
3.
Asset/Liability Management Strategy
4.
Pricing
5.
Terms of ALM Policy
6.
ALM Models
7.
ALM Organisation
8.
ALM Process
9.
Scope of ALM
10.
Implementation Issues
11.
Guidelines of ALM in Banks
12.
Emerging Issues in Indian Context
13.
Challenges faced by ALM
14.
Conclusion
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15.
Bibliography
Index
INTRODUCTION
In banking, asset and liability management (often abbreviated ALM) is the practice of
Managing risks that arise due to mismatches between the assets and liabilities
(debts and assets) of the bank. This can also be seen in insurance.
Banks face several risks such as the liquidity risk, interest rate risk, credit risk and
Operational risk. Asset liability management (ALM) is a strategic management tool to
manage interest rate risk and liquidity risk faced by banks, other financial services
companies and corporations.
Banks manage the risks of asset liability mismatch by matching the assets and
liabilities according to the maturity pattern or the matching of the duration, by
hedging and by securitization. Much of the techniques for hedging stem from the
delta hedging concepts introduced in the BlackScholes model and in the work of
Robert C. Merton and Robert A. Jarrow. The early origins of asset and liability
management date to the high interest rate periods of 1975-6 and the late 1970s and
early 1980s in the United States. Van Deventer, Imai and Mesler (2004), chapter 2,
outline this history in detail.
Modern risk management now takes place from an integrated approach to enterprise
risk management that reflects the fact that interest rate risk, credit risk, market risk,
and liquidity risk are all interrelated. The Jarrow-Turnbull model is an example of a
risk management methodology that integrates default and random interest rates. The
earliest work in this regard was done by Robert C. Merton. Increasing integrated risk
management is done on a full mark to market basis rather than the accounting basis
that was at the heart of the first interest rate sensivity gap and duration calculations.
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Asset Liability Management (ALM) defines management of all assets and liabilities
(both off and on balance sheet items) of a bank. It requires assessment of various
types of risks and altering the asset liability portfolio to manage risk. Till the early
1990s, the RBI did the realbanking business and commercial banks were mere
executors of what RBI decided. But now, BIS is standardizing the practices of banks
across the globe and India is part of this process. The success of ALM, Risk
Management and Basel Accord introduced by BIS depends on the efficiency of the
management of assets and liabilities. Hence these days without proper management
of assets and liabilities, the survival is at stake. A banks liabilities include deposits,
borrowings and capital. On the other side of the balance sheets are assets which are
loans of various types which banks make to the customer for various purposes. To
view the two sides of banks balance sheet as completely integrated units has an
intuitive appeal. But the nature, profitability and risk of constituents of both sides
should be similar. The structure of banks balance sheet has direct implications on
profitability of banks especially in terms of Net Interest Margin (NIM). So it is
absolute necessary to maintain compatible asset-liability structure to maintain
liquidity, improve profitability and manage risk under acceptable limits.
Liquidity management is a provoking idea for the management of the financial

institutions to ponder about and act. But how to act and when to act are the
questions which lead to Assets and Liability Management (ALM), a management tool
to monitor and manage various aspects of risks associated with the balance sheet
management, including the management and balance sheet exposure of the
institutions. In other words, ALM is an ongoing process of formulating, monitoring,
revising and framing strategies related to assets and liabilities in an attempt to
achieve the financial objective of maximizing interest spread or margins for a
given set of risk level. It is not only a liquidity management tool, but also a portfolio
Management tool to alter the composition of assets and liability portfolio to manage
the risk by using various risk mitigating measures. Assets/liability management is an
integral part of the planning process of commercial banks. In fact, asset/liability
management may be considered as one of the three principal components of a
planning system. The three components are:
Asset/liability management which focuses primarily on the day-to-day or week-toweek balance sheet management necessary to achieve short term financial goals.
Annual profit planning and controls which focus on slightly longer term goals and
look at a detailed financial plan over the course of a fiscal or calendar year.
Strategic planning which focuses on the long run financial and non financial
aspects of a banks performance.
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EARLIER PHASE
In the 1940s and the 1950s, there was an abundance of funds in banks in the form of
demand and savings deposits. Because of the low cost of deposits, banks had to
develop mechanisms by which they could make efficient use of these funds. Hence,
the focus then was mainly on asset management. But as the availability of low cost
funds started to decline, liability management became the focus of bank
management efforts.
The ALM, historically, has evolved from the early practice of managing liquidity on
the banks asset side, to a later shift to the liability side and termed liability
management, to a still later realization of using both the assets as well as the
liabilities side of the balance sheet to achieve optimum resources management, i.e.,
an integrated approach. Prior to deregulation, bank funds were
obtained from relatively stable demand deposits and from small time deposits.
Interest rate ceiling limited the extent to which banks could compete for funds.
Opening more branches in order to attract fresh deposits. As a result, most sources
of funds were core deposits which were quite impervious to interest rate movements
in this environment bank fund management concentrate on the control of assets.
he banks ability to grow will be hampered if they do not have access to the funds
required to create assets. They have freedom to obtain funds by borrowing from both
the domestic and international markets. As they tap different source of funds, there is
an increased need for liability management and it becomes an important part of their
financial management. With liability management, banks now have two sources of
funds core deposits and purchased funds with quite different characteristics. For
core deposits, the volume of funds is relatively insensitive to changes in interest rate
levels.. However core deposits have the disadvantage of not being overly responsive
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to management needs for expansion. If a bank experiences sizeable increase in loan

demand, it cannot expect the core deposits to increase proportionately. For
purchased funds, however, the bank can obtain all the funds
that it wants if it is willing to pay the market determined price. Unlike core deposits
where the bank determines the price, the interest rates on purchased funds are set
in the national money market. The bank can be thought of as a price taker in the
purchased funds market whereas in the core deposit market it can be viewed as a
price setter. The purchased funds give complete flexibility in terms of the volumes
and timing of the availability of funds. management, the core deposits offer the
advantage of stability.
However core deposits have the disadvantage of not being overly responsive to
management needs for expansion. If a bank experiences sizeable increase in loan
demand, it cannot expect the core deposits to increase proportionately. For
purchased funds, however, the bank can obtain all the funds that it wants if it is
willing to pay the market determined price. Unlike core deposits where the bank
determines the price, the interest rates on purchased funds are set in the national
money market.
MODERN PERSPECTIVE
The recent volatility of interest rates broadened to include the issue of credit risk and
market risk and to ensure that their risk management capabilities are commensurate
with the risk of their business. The induction of credit risk into the issue of
determining adequacy of bank capital further enlarged the scope of ALM.
.According to policy approach of Basel II in India, to conform to best international
standards and in the process emphasis is on harmonization with the international
best practices. If this were so, the scope and the role of ALM become all the more
enlarged. Incidentally, commercial banks in India will start implementing Basel II with
effect from March 31, 2008 though, as indicated by the governor of the RBI, a
marginal stretching beyond this date can not be ruled out in view of latest indications
of the state of preparedness. In current spell, earning a proper return for the
promoter of equity and maximization of its market value means management of the
balance sheet of the institution.
In other words, this also implies that managements are now expected to target
required profit levels and ensure minimization of risks to acceptable levels, to retain
the interest of the investing community. In todays competitive environment, if the
organization has to remain in the business, costing and product pricing policies have
to be suitably structured. Thus, with the changing requirement, there is a need for
not only managing the net interest margin of the organization but at the same time
ensuring that liquidity is managed, how much liquid the organization has to be
definitely, worked out on the basis of scenario analysis, but the knowledge to
management, adopt the new system and organizational changes that are called for it
to manage, have to be defined. Thus, the concept of ALM is much wider and is of
greater significance
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COMPONENTS OF BANKS BALANCE SHEET

This assets and liabilities of a Bank are divided into various sub heads. For the
purpose of the study, the assets were regrouped under six major heads and the
liabilities were regrouped under four major heads as shown in table below. This
classification is guided by prior information on the liquidity-return profile of assets
and the maturity-cost profile of liabilities. The reclassified assets and liabilities
covered in the study exclude other assets on the asset side and other liabilities on
the liabilities side. This is necessary to deal with the problem of singularity a
situation that produces perfect correlation within sets and makes correlation between
sets meaningless.
Banks Liabilities:
o Capital
o Reserve and Surplus
o
o
o
o
Deposits
Borrowings
Other Liabilities & Pro.
Contingent Liabilities
Banks Assets:
o
o
o
o
o
o
Cash and Balance with RBI

Balance with other banks
Investment
Advances
Fixed assets
Other assets
BALANCE SHEET MIX

ALM policy should establish portfolio limits on the mix of balance sheet liabilities
such as deposits and other types of funding, as a percentage of total assets,
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considering the differential costs and volatility of these types of funds. Similarly,
prudent portfolio limits on the mix of balance sheet assets (e.g. loans by credit
category, financial instruments, etc.) should be set by policy considering differential
levels of risk and return. his recommended practice may not be practical for smaller,
less complex credit unions which have a limited membership base, a simple balance
sheet without much product diversification (e.g. savings and personal loans) or which
do not have sufficient financial resources to effectively promote diversification. If this
is the case, ALM policy should state that an appropriate mix of deposits and other
liabilities will be maintained to reflect member expectations and to correlate (by term
and pricing) to the mix of assets held. The mix of assets (loans, investments) return
should be guided by annual planning targets, lending license constraints and
regulatory restrictions on investments.
The management in the bank would like to ensure that beyond the capital planning
and ALM teams, the stakeholders in each line of business are able to appreciate the
cost of capital required for respective lines of business and how it is impacting the
bottom-line ultimately.
Oracle Financial Services Balance Sheet Planning solution helps fulfill the need for
extending ALM income forecasts and Balance Sheet projections into enterprise
planning activities, thereby rendering a consistent picture of forecasts across the
institution. The integration of planning solutions with the risk and performance
management framework is a major milestone in this direction.
ASSET MANAGEMENT STRATEGY

Some banks had the traditional deposit base and were also capable of achieving
substantial growth rates in deposits by active deposit mobilization drive using their
extensive branch network. For such banks the major concern was how to expand the
assets securely and profitably. Credit was thus the major key decision area and the
investment activity was based on maintaining a statutory liquidity ratio or as a
function of liquidity management. The management strategy in such banks was thus
more biased towards asset management. this Section provides direction on setting
policy constraints on the size and types of loans and investments so as to make the
best use of available funds maximize financial margin while maintaining an
appropriate level of safety. The assets of a credit union can be
classified into two broad categories: earning assets and non-earning assets. ALM
policy should promote the maximization of earning assets which reward the credit
union for its operating risks. Earning assets are those assets which generate direct
revenues for the credit union.
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LIABILITY MANAGEMENT STRATEGY

Some banks on the other hand were unable to achieve retail deposit growth rates
since they did not have a wide branch network. But these banks possessed superior
asset management skills and hence could fund assets by relying on the wholesale
markets using Call money, CDs Bill Rediscounting etc. Deregulation of interest rates
coupled with reforms in the money market introduced by the reserve bank provided
these banks with the opportunity to compete with funds from the wholesale market
using the pricing strategy to achieve the desired volume, mix and cost. So under the
Liability management approach, banks primarily sought to achieve maturities and
volumes of funds by flexibly changing their bid rates for funds.
OBJECTIVES:
When a bank needs funds to cover deposit withdrawals or ton expand its loans to
acquire other assets, it can obtain the needed funds in two ways. One way of
acquiring funds is to liquidate some of the short term assets that the bank holds in
units liquidity account for this purpose. A bank can also obtain funds by acquiring
additional liabilities i.e. by buying the funds it needs.
Basically, liability management seeks to control the sources of funds that a bank can
obtain quickly and in large amounts, unlike demand and savings deposits, which
cannot be increased to any great degree over a short time period. Depending on
cost and availability, a bank will use a variety of liability management instruments to
obtain the liquidity needed for daily cash management, for loan expansion, and for
other earnings opportunities. Liability management provides a bank with an
alternative to asset liquidation to obtain needed funds, and the bank chooses
between these alternatives based on the relative costs and risks involved.
For example: depending on a banks size and on market conditions, a bank in need
of liquidity may chose to borrow government funds or issue CDs rather than sell T
bills or other liquid assets.
Liability management also provides a bank with an alternative to asset management
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in obtaining the greatest value from inflows of funds. therefore a bank which follows
both assets and liability management strategies has the option of using cash inflows
to obtain more short term liquid assets or to repay outstanding liabilities, depending
on which option provides the best combination of earnings and safety.
BENEFITS OF LIABILITY MANAGEMENT:
he key benefit of using Liability Management as a funding strategy is that it provides
a bank with an alternative to asset management for short term adjustments of
funds. For example: Assume that the bank experiences a sudden and unexpected
marked decline in the level of its demand deposits. If the banks only source liquidity
is its assets, it must sell some of its securities to obtain the funds needed to cover
the run off of its deposits, whether or not market conditions are favorable. With
liability management, the bank may be able to raise the needed funds by incurring
liabilities, thereby postponing the sale of its assets until conditions are more
favourable.
Liability management also provides a bank with the means of funding long term
growth. It does so by enabling a bank to expand its loans ad other assets by
managing its liabilities so that a certain volume of its liabilities remains
outstanding at all times so that it can build up on its deposit levels and thereby
expand the level of its loans. This approach of funding is normally followed within a
context of a long term upswing in the economy in which the borrowers seek more
loans for business expansion and depositors place their funds in negotiable time
certificates to earn competitive rates. In such cases, bank management must have a
clear idea of the level of outstanding liabilities that it can count on holding through
tight money periods by offering competitive rates.
Another benefit of liability management is that it allows banks to invest greater
percentage of its available funds in its securities that provide less liquidity but offer
higher earnings, this is possible because the banks liquidity account doesnt have to
bear the full burden of the banks liquidity needs. A bank that has the option of
obtaining liquidity through its liabilities has an opportunity to increase profitability
because it can reduce the amount of short term assets it holds for liquidity purposes
and place those funds into longer term securities that offer less liquidity but offer
higher earnings.
RISKS INVOLVED IN LIABILITY MANAGEMENT:

Although the use of liability management along with asset management allows a
bank the least costly method of obtaining liquidity from a wider range of funding
options, but the added options that liability management provides also require
greater complexity in planning and executing funds management strategies. This is
so since banks can obtain money market deposits and liabilities only by paying
market rates and the behaviour of financial markets cannot be predicted with
complete accuracy.
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Another risk involved is that of issuing long term fixed rate CDs at the peak of the
business cycle. This results in more costly CDs in the future with a fall in the interest
rates. In fact if short term assets are funded by long term liabilities and rates
subsequently decline, a bank may find that it is paying more for funds than it can
earn on those funds.
Another risk that relates to the changing market conditions is the stability of the
banks sources of borrowed or purchased funds. While large money center banks
are usually able to obtain funds under tight money conditions if they are willing to pay
market rates, smaller banks may find it impossible to compete for funds when prices
are high. The risk that a funding house may prove unreliable is also a real problem
for smaller banks that move outside their trading areas or that undertake funding by
means of liability instruments with which they are not completely familiar. Such banks
face the very real possibility that their sources of funds may disappear just when they
are most needed. The basic benefits of liability management lie in the options it
provides a bank in obtaining a least costly method of funding given the banks
particular needs and the existing conditions of the financial markets. The risk
involved in liability management basically results from too much reliance on the use
of purchased funds without recognizing the impact that changing market
conditions or other unanticipated changes can have on the banks ability to secure
funds when the money is scarce.
Non-earning assets should therefore be minimized, i.e. investment in cash, nonaccrual loans/investments and capital (e.g. fixed) assets. Under Regulation 76/95,
there is a requirement for credit unions to maintain a certain amount of its assets in
liquid form. This liquidity need not be held in cash, but can be in the form of callable
deposits of a league or a Canadian chartered bank/trust company (see section 16 of
Regulation 76/95). Despite the legal flexibility, surplus cash is often left on the
premises of a credit union rather than being placed into interest bearing accounts.
Operational procedures should limit the maximum amount of cash left on premises.
High teller floats or ATM balances, excessive funds in transit (e.g. balances that are
not cleared daily for deposit with the league), or idle cash in non-interest current
accounts will increase the amount of non-earning assets and lower financial spread.
In the case of teller floats or ATM balances, operational procedures should set
maximum limits that can still accommodate members' needs.
ADVANTAGES
ALM can help protect a financial institution or corporation against a variety of
financial and nonfinancial risks.
he mere process of identifying risks enables businesses to be better prepared to
deal with these risks in the most cost-effective way.
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ALM ensures that a companys capital and assets are used in the most efficient
way.
It can be used as a strategic and business tool to improve earnings.
DISADVANTAGES
ALM is only as good as the people on the ALM committee and the operational
procedures that they follow.
ALM can prove costly in terms of both the time required of employees and the
investment required in management tools such as IT and techniques such as
hedging.
ASSET/LIABILITY MANAGEMENT PHILOSOPHY
Adopting an asset/liability management philosophy is an important first step in

drafting ALM policy. The philosophy should set out the broad goals and objectives of
the credit unions asset/liability portfolio, as established by the board of directors,
who represent the membership at large. This philosophy governs all ALM policy
constraints and helps address new situations where policy does not yet exist. While
goals and objectives will differ depending upon the circumstances and environment
of the credit union, the ALM philosophy should always address the following
principles:
he credit union will manage its asset cash flows in relation to its liability cash flows
in a manner that contributes adequately to earnings and limits the risk to the financial
margin.
Product terms, pricing and balance sheet mix must balance members product
demands with the need to protect the equity of the credit union.
Financial derivatives instruments must only be used to limit interest rate risk and
must never be used for speculative or investment purposes.
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PRICING
ALM policy specifies that the pricing of all loans and deposits offered should be
established so that overall, a net contribution to earnings is provided. In order to
ensure that deposit and lending rates are sufficiently responsive, policy may
delegate to management the authority to set interest rates without board approval
but in accordance with pre-established criteria as described below:
Deposit Pricing Policy:

Rates offered on deposits should be tied to external benchmarks in the local market
and should generally approximate the average of these market indicators (for
example, the bank rate or the prime rate). Policy should allow management flexibility
to negotiate more favorable rates within a prescribed range to maintain key deposit
accounts. In order to protect financial margin, credit unions should avoid engaging in
price wars with competitor financial institutions including other credit unions. Pricing
strategies of competitor institutions will reflect the need for funds in these
organizations. Liquidity requirements of the competitor institution may differ vastly
from the credit union's needs; therefore, caution should be exercised when setting
rates.
Loan Pricing Policy:

It is recommended that loans be priced at market rates and subject to interest rate
rebates only at the end of the year, if sufficient earnings and reserves are available.
The interest rates offered on loans should reflect an adequate margin above the
rates on deposits being used to fund loans, in order to cover all operating expenses
and capital requirements. Loan pricing can also be used to balance minor gap
mismatches. Where funding from deposits is high for a particular term of loan, the
price for these loans could be made more attractive than terms whose funding
sources are scarce. For larger gap mismatches, however, a derivative instrument
may be a more practical option. Loan pricing is crucial for establishing a successful
lending program. In order to establish fair interest rates for both the borrower and
the credit union, the following factors should be considered:
Cost of funds and the spread required for financing the loan.
Market rates offered by the competition.
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Excess liquidity position of the credit union.

Maturity and repayment terms of the loan.
Credit risk of the loan (e.g. loan purpose, size and security).
Length of loan amortization period (generally, the longer the period, the higher the
rate).
Share Pricing Policy:

When issuing capital shares, discretionary dividend rates should be subject to ALM
policy criteria approved by the board. Dividend rates should be set with due regards
to the average cost of alternative funds such as deposits, other classes of shares
and borrowings. When stock dividends are offered as an alternative to cash
dividends, the future costs of increased fixed dividends should be analyzed for
ongoing affordability, before stock dividends are declared.
TERMS OF ALM POLICY

ALM policy should set reasonable limits on the terms of loans and deposits. These
limits should be broad enough so that management can set varying terms for
individual products in operational procedures based on product purpose, so long as
these do not exceed the maximum term limits approved by the board. here are no
regulatory requirements for the maximum term on any assets or liabilities which a
credit union can assume.
Term Deposits:
It is recommended that the board establish maximum term limits on term deposits.
Operational procedures can describe the availability of alternative term deposits and
correlate differential pricing for these products within this limit. he board may want to
set a general five year maximum term on deposits in policy, and require that any
products with terms greater than five years require special board approval.
Term Loans:
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It is recommended that the board establish maximum term limits on term loans.
Operational procedures can describe the availability of alternative term loans and
correlate differential pricing for these products within this limit. he board may want to
set a general five year maximum term on loans in policy, and require that any
products with terms greater than five years require special board approval.
Operational Procedures:
he criteria for offering term loans of varying length can be specified in operational
procedures. Operational procedures can require that loan terms be set to similar
lengths as the life of the security (e.g. large loans secured by higher valued assets
would normally have longer terms to maturity). Due to the higher repayment and
security risks of longer term loans, and the usually limited consumer demand for
term deposits in excess of five years, it is recommended that generally, term loans
be offered with five year maximum maturities.For increased competitiveness,
however, loan maturities in excess of five years may occasionally be sanctioned up
to a prescribed policy limit or approved by the board on an exception basis.
Mortgage terms of seven to ten years have become more commonplace in the
market but generally should only be offered by credit unions if arrangements are in
place to manage the gap between five year funding deposits and those longer term
mortgages. Credit unions should consult with their league for appropriate strategies
prior to offering extended term mortgages. term loans should be substantially
matched by contractual maturity dates against non-callable term deposits. For
mortgages with terms exceeding one year, selective prepayment penalties should be
established by operational policy.
ALM STRATEGY
As interest rated in both the liability and the asset side were deregulated, interest
rates in various market segments such as call money, CDs and the retail deposit
rates turned outdo be variable over a period of time due to competition and the need
to keep the bank interest rates in alignment with market rates. Consequently the
need to adopt a comprehensive Asset- liability strategy emerged, the key objectives
of which were as under.
he volume, mix and cost/return of both liabilities and assets need to be planned
and monitored in order to achieve the banks short and long term goals.
Management control would comprehensively embrace all the business segments
like deposits, borrowing, credit, investments, and foreign exchange. It should be
coordinated and internally consistent so that the spread between the banks earnings
from assets and the costs of issuing liabilities can be maximized.
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Suitable pricing mechanism covering all products like credit, payments, and
custodial financial advisory services should be put in place to cover all costs and
risks.
STRATEGIC APPROACHES TO ALM

Spread Management : his focuses on maintaining an adequate spread between a
banks interest expense on liabilities and its interest income on assets.
Gap Management: his focuses on identifying and matching rate sensitive assets
and liabilities to achieve maximum profits over the course of interest rate cycles A
bank will price the loan even taking the liquidity risk. Incorporating the default
probabilities helps the bank to price the loan appropriately in line with its risk profile.
Hence bank would also look at the impact of such a loan on its liquidity along with
the credit risk and not in isolation. The bank would now have flexibility in accepting
and rejecting the loan only after having considered all parameters. It will provide the
necessary direction to the bank in structuring the loan in such a way, that liquidity
profile of the bank is improved. If the liquidity profile of the portfolio is improved the
loan can be priced favorably for the borrower. This model helps us to identify those
loans that contribute to the ROA and Roe of the bank. This puts the bank on the road
to SHAREHOLDER VALUE CREATION. By identifying the acceptable risk limits, the
bank achieves greater stability thus ensuring higher returns for the shareholders.
While a similar system might already be in use in several competitive banks in one
form or the other, other banks that do not employ such a system in totality might find
it useful to adopt the integrated ALM approach which has been presented as a
conceptual argument
ALM MODELS
Analytical models are very important for ALM analysis and scientific decisionmaking. The basic models are:
1. GAP Analysis Model
2. Duration GAP Analysis Model
3. Scenario Analysis Model
4. Value at Risk (VaR) model
5. Stochastic
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Programming Model : Any of these models is being used by banks through their
Asset Liability Management Committee (ALCO). The Executive Director and other
vital departments heads head ALCO in banks. There are minimum four members
and maximum eight members. It is responsible for Responsible for Setting business
policies and strategies, Pricing assets and liabilities, Measuring risk, Periodic review,
Discussing new products and Reporting. Gap analysis model: Measures the
direction and extent of asset-liability mismatch through either funding or maturity
gap. It is computed for assets and liabilities of differing maturities and is calculated
for a set time horizon. This model looks at the reprising gap that exists between the
interest revenue earned 9n the bank's assets and the interest paid on its liabilities
over a particular period of time (Saunders, 1997). It highlights the net interest
income exposure of the bank, to changes in interest rates in different maturity
buckets. Reprising gaps are calculated for assets and liabilities of differing
maturities. A positive gap indicates that assets get reprised before liabilities,
whereas, a negative sensitivity (the time the bank manager will have to wait in order
to change the posted rates on any asset or liability) of each asset and liability on the
balance sheet. The general formula that is used is as follows:
NIIi= R i (GAPi)
While NII is the net interest income, R refers to the interest rates impacting assets
and liabilities in the relevant maturity bucket and GAP refers to the differences
between the book value of the rate sensitive assets and the rate sensitive liabilities.
Thus when there is a change in the interest rate, one can easily identify the impact of
the change on the net interest income of the bank. Interest rate changes have a
market value effect. The basic weakness with this model is that this method takes
into account only the book value of assets and liabilities and hence ignores their
market value. This method therefore is only a partial measure of the true interest rate
exposure of a bank.
FUTURE GAPS:
It is possible that the simulation model due to the nature of massive paper outputs
may prevent us from seeing wood for the tree. In such a situation, it is extremely
important to combine technical expertise with an understanding of issues in the
organization. There are certain requirements for a simulation model to succeed.
These pertain to accuracy of data and reliability of the assumptions made. In other
words, one should be in a position to look at alternatives pertaining to prices, growth
rates, reinvestments, etc., under various interest rate scenarios.
This could be difficult and sometimes contentious. It is also to be noted that
managers may not want to document their assumptions and data is not easily
available for differential impacts of interest rates on several variables. Hence,
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simulation models need to be used with caution particularly in the Indian situation.
Last but not the least, the use of simulation models calls for commitment of
substantial amount of time and resources. If we cannot afford the cost or, more
importantly the time involved in simulation modelling, it makes sense to stick to
simpler types of analysis.
Duration model:
Duration is an important measure of the interest rate sensitivity of assets and
liabilities as it takes into account the time of arrival of cash flows and the maturity of
assets and liabilities. It is the weighted average time to maturity of all the preset
values of cash flows. Duration basic
-ally refers to the average life of the asset or the liability.
DP p = D ( dR /1+R)
he above equation describes the percentage fall in price of the bond for a given
increase in the required interest rates or yields. The larger the value of the duration,
the more sensitive is the price of that asset or liability to changes in interest rates. As
per the above equation, the bank will be immunized from interest rate risk if the
duration gap between assets and the liabilities is zero. The duration model has one
important benefit. It uses the market value of assets and liabilities.
Value at Risk:
Refers to the maximum expected loss that a bank can suffer over a target horizon,
given a certain confidence interval. It enables the calculation of market risk of a
portfolio for which no historical data exists. It enables one to calculate the net worth
of the organization at any particular point of time so that it is possible to focus on
long-term risk implications of decisions that have already been taken or that are
going to be taken. It is used extensively for measuring the market risk of a portfolio of
assets and/or liabilities.
Simulation:
Simulation models help to introduce a dynamic element in the analysis of interest
rate risk. Gap analysis and duration analysis as stand-alone too15 for asset-liability
management suffer from their inability to move beyond the static analysis of current
interest rate risk exposures. Basically simulation models Utilize computer power to
provide what if scenarios,
for example: What if: the. Absolute level of interest rates shift. There are nonparallel
yield curve changes
Marketing plans are under-or-over achieved
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Margins achieved in the past are not sustained /improved

Bad debt and prepayment levels change in different interest rate scenarios
There are changes in the funding mix. for e.g.: an increasing reliance on short
term funds for balance sheet growth. This dynamic capability adds value to the
traditional methods and improves the information available to management in terms
of:
Accurate evaluation of current exposures of asset and liability portfolios to
interest rate risk.
Changes in multiple target variables such as net interest income, capital
adequacy, and liquidity.
ALM Organization
T he Board of Directors would have the overall responsibility for the ALM & risk
management and should 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 operating them. Typically, ALCO consists of the senior
management, including the Chief Executive. Needless to say ALCO has to be
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. In addition to
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monitoring the risk levels of the bank, the ALCO should review the results of and
progress in implementation of the decisions made in the previous meetings. The
ALCO would also articulate the current interest rate view of the bank and base its
decisions for future business strategy on this view. In respect of the funding policy,
for instance, its responsibility would be to decide on source and mix of liabilities or
sale of assets. Towards this end, it will have to develop a view on future direction of
interest rate movements and decide on a funding mix between fixed vs. floating rate
funds, wholesale vs. retail deposits, money market vs. capital market funding,
domestic vs. foreign currency funding, etc. Individual banks will have to decide the
frequency for holding their ALCO meetings.
COMPOSITION OF ALCO
he size (number of members) of ALCO would depend on the size of each institution,
business mix and organizational complexity or ensure commitment of the
Management, the CEO/CMD or ED should head the Committee. The Chiefs of
Investment, Credit, Funds Management / Treasury (forex and domestic),
International Banking and Economic Research can be members of the Committee. In
addition the Head of the Information Technology Division should also be an invitee
for building up of MIS and related computerization. Some banks may even have subcommittees.
COMMITTEE OF DIRECTORS
Banks should also constitute a professional Managerial and Supervisory Committee
consisting of three to four directors which will oversee the implementation of the
system and review its functioning periodically. The content of d asset liability
management includes:
Background & Overview of Asset and Liability Committee (ALCO)

Role & Objectives
Sample Statements on Role / Function of ALCO
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Capital of a financial institution

Funding and Liquidity
Structural Market Risk of on and Off Balance Sheet items
Asset / Liability Composition

What comprises Assets?
What comprises Liability?
Detail discussion on characteristics of the major assets and liabilities
Sample Balance Sheet of some local commercial banks
Off Balance-Sheet items
Role of ALCO in Capital Management

Minimum Capital Standards and Compliance
Capital Structure of a Banking Institution
Regulatory Capital, Compliance & Maintenance Illustration : Sub-Prime crisis
impact on Banks Capital
What would ALCO look at Capital Adequacy
Growth of Assets-Liabilities and adequacy of Capital
Role of ALCO in Funding and Liquidity Management

Liquidity Structure and Regulatory Framework
Liquidity Concept and Objectives (MCO, MCI)
Money Market, Liquidity and their significance to Banking Institutions
Regulatory Framework and Compliance
Regulatory Limits, Ratios, Utilization
Liquidity Profile and Associated Risks :
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Growth in Asset-Liability Types and implication on Liquidity

Assessment of Change in Liquidity Profile
ALCOs Role, Objectives, Actions
GOAL OF COMMITTEE
Management of assets and liability incorporates interest rate risk and liquidity
considerations into a bank's operating model. From a regulatory perspective, one of
the ALCO's goals is to ensure adequate liquidity while managing the bank's spread
between the interest income and interest expense. Investments and operational risk
are also major considerations. A sound practice is to conduct ALCO meetings at
least quarterly to review the bank's level of exposure to changing interest rates and
to determine management's degree of compliance with internal policies and
quantitative parameters, such as limits and ratios. ALCO responsibilities include
managing market risk tolerances, establishing appropriate MIS, reviewing and
approving the liquidity and funds management policy at least annually, approving a
contingency funding plan, and reviewing immediate funding needs and sourcespossibly engaging an independent third party to validate the assumptions and data
contained in internally or externally prepared management reports.
ALM PROCESS
The ALM process rests on three pillars:
ALM information systems
=> Management Information System
=> Information availability, accuracy, adequacy and expediency
ALM organization
=> Structure and responsibilities
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=> Level of top management involvement

ALM process
=> Risk parameters
=> Risk identification
=> Risk measurement
=> Risk management
=> Risk policies and tolerance levels
ASSET-LIABILITY MANAGEMENT AND FINANCIAL GOALS

Credit unions have many financial goals; however, two are basic to their survival:
first, earn net income and second, remain solvent, or able to meet demands for cash
(such as payment of operating expenses). Earnings allow a credit unions capital to
increase, which is necessary for growth. Credit union managers must focus on
asset-liability management because fluctuating interest rates, intense competition,
consolidation, and member demands for better, more efficient, more convenient
products can reduce earnings and, therefore, capital. A credit union must manage its
cash flowing into and out of its assets and liabilities and the interest rates related to
its financial products. Understanding the characteristics of cash flow is necessary to
adequately measure interest- rate risk and stay solvent.
RISK MEASUREMENT AND BOARD REPORTING

It is recommended that the credit union measure the performance and risk level of
the credit unions asset/liability management activities, and report these findings to
the board.
Risk Measurement:
The following are minimum risk and performance measures of ALM, required by
sound business and financial practices:
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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 should be compared to financial targets
in the annual business plan and the budget, so that management can determine
whether the credit union is meeting its goals. Management can also assess whether
there are material variances from the plan which need to be addressed.
Risk Management Techniques

Sections 7401 to 7405 provide techniques for measuring and monitoring the
adequacy of the credit union's ALM activities.
Board Reports
The above measurements should be reported to the board of directors, so that the
board can also monitor ALM activities and ensure adherence to regulatory
requirements and to the annual business plan. Material variances from plan, and
their causes, as well as management's plan to correct the variance should also be
included in the report. Management should also provide the board with a summary
on compliance with ALM policy and relevant regulatory requirements.
Credit score of risk in asset liability management
The credit score is the result of the credit appraisal process. It is at this stage that
the credit risk is quantified in terms of default probabilities. The interest rate score
reflects the spread earned by the corporate bank over and above the transfer price.
The liquidity score reflects the impact of the proposal on the liquidity profile of the
bank. Every bank would have certain target Gaps. Every proposal either takes the
bank away from the target Gap or brings it closer to the same. This score reflects the
impact of the proposal on the Gap profile of the bank. The score also is a reflection
of the cost of funding the liquidity mismatch that it might create. This looks at the
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possibility of a credit default. This kind of arrangement, however, demands, diligent

monitoring of the asset to keep the bank updated with its liquidity profile.
Asset Evaluation:
Once the three performance scores are available, the entire evaluation of the asset
can be condensed to a one-page report. Here the performance measures are graded
on a scale of 1-5. The weighted average of these scores will give us the
COMPOSITE SCORE of the loan, the weights being assigned on the basis of the
relative strategic importance of each of these three parameters specific to the bank.
Higher the composite score better is the chance of the loan being accepted The
calculation of the composite score has certain underlying requirements: Every bank
should have a minimum composite score based on its risk appetite. E g., if we fix a
minimum composite score of 2, then any loan with a score below 2 should be
rejected, no questions asked.
A bank might have a minimum composite score of two, but care should be taken to
see to it that most of the loans in the portfolio do not fall very close to the minimum
composite score as this would worsen its risk profile. Weights should be assigned to
the different performance scores based on the banks future strategies and the
current balance sheet status. E.g., a bank with heavy focus on the control of already
high NPAs should give higher weights to credit performance score.
SCOPE OF ALM
The scope of ALM function can be described as follows:

I. Liquidity risk management
II. Management of market risks(including Interest Rate Risk)
III Funding and capital planning
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IV. Profit planning and growth projection

V. Trading risk management
The guidelines given in this note mainly address Liquidity and Interest Rate risks.
The guidelines specify the use of a maturity ladder up to 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. For instance, the trading book securities
are to be shown less than one day to 30 days, over 1 month & up to 2 months, etc.,
time buckets on the basis of defeasance periods. 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, banks need to estimate the future behaviour 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.
I. Liquidity Risk Management:

Measuring and managing liquidity needs are vital activities of commercial banks. By
assuring a bank's ability to meet its liabilities as they become due, liquidity
management can reduce the probability of an adverse situation developing. The
importance of liquidity transcends individual institutions, as liquidity shortfall in one
institution can have repercussions on the entire system. Bank management should
measure not only the liquidity positions of banks on an ongoing basis but also
examine how liquidity requirements are likely to evolve under crisis scenarios.
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Experience shows that assets commonly considered as liquid like Government

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 net funding
requirements, 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. he Maturity
Profile as given could be used for measuring the future cash flows of banks in
different time buckets. The time buckets given the Statutory Reserve cycle of 14
days may be distributed as under:
1 to 14 days
15 to 28 days
29 days and up to 3 months
Over 3 months and up to 6 months
Over 6 months and up to 12 months
Over 1 year and up to 2 years
Over 2 years and up to 5 years
Over 5 years
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., 1-14 days and 15-28 days. Banks, however,
are expected to monitor their cumulative mismatches (running total) across all time
buckets by establishing internal prudential limits with the approval of the Board /
Management Committee. The mismatch during 1-14 days and 15-28 days should not
in any case exceed 20% of the cash outflows in each time bucket. If a bank in view
of its asset -liability profile needs higher tolerance level, it could operate with higher
limit sanctioned by its Board / Management Committee giving reasons on the need
for such higher limit. A copy of the note approved by Board / Management
Committee may be forwarded to the Department of Banking Supervision, RBI. The
discretion to allow a higher tolerance level is intended for a temporary period, till the
system stabilizes and the bank is able to restructure its asset -liability pattern. he
Statement of Structural Liquidity may be prepared by placing all cash inflows and
outflows in the maturity ladder according to the expected timing of cash flows. A
maturing liability will be a cash outflow while a maturing asset will be a cash inflow. It
would be necessary to take into account the rupee inflows and outflows on account
of forex operations including the readily available forex resources ( FCNR (B) funds,
etc) which can be deployed for augmenting rupee resources. While determining the
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likely cash inflows / outflows, banks have to make a number of assumptions

according to their asset - liability profiles. For instance, Indian banks with large
branch network can (on the stability of their deposit base as most deposits are
renewed) afford to have larger tolerance levels in mismatches if their term deposit
base is quite high. While determining the tolerance levels the banks may take into
account all relevant factors based on their asset-liability base, nature of business,
future strategy etc. The RBI is interested in ensuring 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 banks to monitor their short-term liquidity on a dynamic basis
over a time horizon spanning from 1-90 days, banks may estimate their short-term
liquidity profiles
On the basis of business projections and other commitments. An indicative format
for estimating Short-term Dynamic Liquidity is enclosed.
Scenario Analysis:
Liquidity analysis scenarios are generated. A typical measure would involve worst
case (MCO analysis), best case and likely. (This may be used to commit money in
money markets). 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 predefined. Recent volatility in the wholesale funding markets has served to highlight
the importance of sound liquidity risk management practices and reinforce the lesson
that those banks with well- developed risk management functions are better
positioned to respond to new funding challenges. The banking industry has
developed many innovative solutions in response to these challenges, some of
which are presented here. Because banks vary widely in their funding needs, the
composition of their funding, the competitive environment in which they operate, and
their appetite for risk, there is no one set of universally applicable methods for
managing liquidity risk.
Strategic Direction
Bank management, generally through ALCO, must articulate the overall strategic
direction of the banks funding strategy by determining what mix of assets and
liabilities will be utilized to maintain liquidity. This strategy should address the
inherent liquidity risks, which are generated by the institutions core businesses. For
instance, if the bank has major positions in global capital markets, then liquidity
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should be managed to lessen the impact of sudden changes in global markets. Or if

the bank funds commercial loans with core deposits, then liquidity should be
managed to reduce the impact of a decline in asset quality or a runoff of core
deposits. This strategy must be documented through a comprehensive set of policies
and procedures and communicated throughout the bank.
Integration
Liquidity management must be an integral part of asset/liability management. The
banks asset and liability management policy should clearly define the role of liquid
assets along with setting clear targets and limits. In the past, asset/liability
managements goal was primarily to maximize revenue while liquidity management
was managed separately. This resulted in situations where asset and liability profiles
structured for maximum profitability had to be reconfigured (often at a loss) to meet
sudden liquidity demands. While the struggle between maximizing profitability and
providing adequate liquidity continues to this day, the best ALCO groups have
realized that liquidity management must be integral to avoid the steep costs
associated with having to rapidly reconfigure the asset/liability profile from maximum
profitability to increased liquidity. Some of the greatest changes in risk management
have occurred in the integration area. Instead of liquidity management being the
responsibility of a small group of staff, it is now integrated into the day-to-day
decision-making process of core business line managers. This is frequently done
through the use of loan growth and balance sheet targets that are pushed down to
business line managers. Some banks achieve this goal through the use of a transfer
pricing system - giving liquidity-generating business lines an internal earnings credit
while charging liquidity-using business lines cost centers for funding. Another
innovative method is to require business lines to structure deals as if they had to
fund them on a stand-alone basis.
Measurement Systems
Most banking experts agree that maintaining an appropriate system of metrics is the
linchpin upon which the liquidity risk management framework rests. If they are to
successfully manage their liquidity position, management needs a set of metrics with
position limits and benchmarks to quickly ascertain the banks true liquidity position,
ascertain trends as they develop, and provide the basis for projecting possible
funding scenarios rapidly and accurately. In addition, the bank should establish
appropriate benchmarks and limits for each liquidity measure. The varied funding
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needs of institutions preclude the use of one universal set of metrics. As a result,
banks frequently use a combination of stock and flow liquidity measures or have
gone to exclusive reliance on models. Stock measures look at the dollar levels of
either assets or liabilities on the balance sheet to determine whether or not these
levels are adequate to meet projected needs. Flow measures use cash inflows and
outflows to determine a net cash position and any resultant surplus or deficit levels of
funding. Models are built utilizing hypothetical scenarios to develop measures,
benchmarks, and limits. Balance-sheet-based measures are generally best suited to
smaller institutions which fund their business lines, generally loans, with core
deposits. These banks generally develop their measurement system and their
corresponding benchmarks and limits based on either selected peer group analysis
or on studies of historical liquidity needs over time. In addition, most of these banks
utilize flow measures to determine their net cash position. While this combination
works well for smaller banks, regional and global institutions that have significant
trading operations and are heavily reliant on purchased funding find that stock and
flow measures are no longer adequate to meet their needs. As a result, these banks
have either developed or have purchased model-based measurement systems to
assist them in liquidity measurement.
Currency Risk:
Floating exchange rate arrangement has brought in its wake pronounced volatility
adding a new dimension to the risk profile of banks' balance sheets. The increased
capital flows across free economies following deregulation have contributed to
increase in the volume of transactions. Large cross border flows together with the
volatility has rendered the banks' balance sheets vulnerable to exchange rate
movements. Dealing in different currencies brings opportunities as also risks. If the
liabilities in one currency exceed the level of assets in the same currency, then the
currency mismatch can add value or erode value depending upon the currency
movements. The simplest way to avoid currency risk is to ensure that mismatches, if
any, are reduced to zero or near zero. Banks undertake operations in foreign
exchange like accepting deposits, making loans and advances and quoting prices for
foreign exchange transactions. Irrespective of the strategies adopted, it may not be
possible to eliminate currency mismatches altogether. Besides, some of the
institutions may take proprietary trading positions as a conscious business strategy.
Managing Currency Risk is one more dimension of Asset- Liability Management.
Mismatched currency position besides exposing the balance sheet to movements in
exchange rate also exposes it to country risk and settlement risk. Ever since the RBI
(Exchange Control Department) introduced the concept of end of the day near
square position in 1978, banks have been setting up overnight limits and selectively
undertaking active day time trading. Following the introduction of "Guidelines for
Internal Control over Foreign Exchange Business" in 1981, maturity mismatches
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(gaps) are also subject to control. Following the recommendations of Expert Group
on Foreign Exchange Markets in India (Sodhani Committee) the calculation of
exchange position has been redefined and banks have been given the discretion to
set up overnight limits linked to maintenance of additional Tier I capital to the extent
of 5 per cent of open position limit. Presently, the banks are also free to set gap limits
with RBI's approval but are required to adopt Value at Risk (VaR) approach to
measure the risk associated with forward exposures. Thus the open position limits
together with the gap limits form the risk management approach to forex operations.
For monitoring such risks banks should follow the instructions contained in Circular
A.D (M. A. Series) No.52 dated December 27, 1997 issued by the Exchange Control
Department.
II. Management of market risks(including 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. For example, if a bank provides a 10 year
housing loan, then it is has to locate 10 year assets to minimize market risk for that
loan. Both traded and non-traded assets and liabilities carry market risk and any
technique should address this. All products carry market risk and this need to be
addressed as well. It must be understood that all statistical techniques are
forecasting algorithms based on history in some form or the other. There is no
guarantee that history will repeat itself and new paths and patterns may emerge.
Statistical techniques help make judgments. They are not replacements for flesh and
blood managers. 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 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. traditionally, banks have a trading book and a banking book. The Basel
Committee also uses this differentiation. The essential distinction between a banking
book and a trading book is in the method used for the recognition of the risks and
valuation.
For purposes of determining interest rate sensitivity, both books may be mapped to
zero coupon bonds, preserving market risk. Combined book represents a reasonable
estimate of banks interest rate risk profile. The application of techniques like
modified or dollar duration gap and convexity gap analysis to such a profile will
enable risk measurement of interest rate sensitivity.
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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. Buckets may be determined carefully.
Making buckets too small leaves a large number of buckets. Making them too large
may hide some sensitivity issues Gaps may be identified in the following time
buckets:
I) up to 1 month
ii) Over one month and up to 3 months
iii) Over 3 months and up to 6 months
iv) Over 6 months and up to 12 months
v) Over 1 year and up to 3 years
vi) Over 3 years and up to 5 years
vii) Over 5 years
viii) Non-sensitive
Therefore, the banking industry in India has substantially more issues associated
with interest rate risk, which is due to circumstances outside its control. This poses
extra challenges to the banking sector and to that extent; they have to adopt
innovative and sophisticated techniques to meet some of these challenges. There
are certain measures available to measure interest rate risk. These include:
Maturity: Since it takes into account only the timing of the final principal payment,
maturity is considered as an approximate measure of risk and in a sense does not
quantify risk. Longer maturity bonds are generally subject to more interest rate risk
than shorter maturity bonds.
Duration: Is the weighted average time of all cash flows, with weights being the
present values of cash flows. Duration can again be used to determine the sensitivity
of prices to changes in interest rates. It represents the percentage change in value in
response to changes in interest rates.
Dollar duration: Represents the actual dollar change in the market value of a
holding of the bond in response to a percentage change in rates.
Convexity: Because of a change in market rates and because of passage of
time, duration may not remain constant. With each successive basis point movement
downward, bond prices increase at an increasing rate. Similarly if rates increase, the
rate of decline of bond prices declines. This property is called convexity.In the Indian
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context, banks in the past were primarily concerned about adhering to statutory
liquidity ratio norms and to that extent they were acquiring government securities and
holding it till maturity. But in the changed situation, namely moving away from
administered interest rate structure to market determined rates, it becomes important
for banks to equip themselves with some of these techniques, in order to immunize
banks against interest rate risk.
Credit Derivatives:
The role of a bank in any economic system is financial intermediation. This
essentially involves borrowing and lending of funds and assuming the risk of lending
in the process. Current banking practices view the management of credit risk outside
the scope of the ALM framework. Credit risk, as most bankers claim, is taken care of
by having stringent lending preconditions and diligent monitoring of the loan portfolio.
The regulators are happy with stringent reporting norms with reference to provisions
for non-performing assets. However, in a banking system where 40% of the loan
able funds are locked in the priority sector and competitive pressures often driving
the banks to compromise on the self-devised stringent lending norms, the fact that
banks carry substantial credit risk on their balance sheets cannot be ignored. When
one talks of lending, the first issue that should come up is the borrowers credibility.
Credit risk management is not a new concept. Exposure to credit risk has long been
hedged or reduced through portfolio diversification, collateral and by making
provisions against possible defaults. In todays global market, these tools seem
inefficient and the time- honored view of the credit market needs re-examining.
Credit risk differs from market risk in that the default risk of an individual company is
tied to its own performance and not to the performance of other companies. In fact,
there is a low correlation between the default risk of an individual counterparty and
any aggregate index of corporate performance such as the market index. So, default
risk cannot be hedged by means of a market index, future contracts or by matching
within the existing book. The only way actually today off default risk is by means of
some instrument that is directly related to the specific comp
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
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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 behavior. These parts are volatile and core. Core is
expected to be with the bank and will mature 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 behavior. 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 US Dollar at a certain rate, bank has to hedge by taking a corresponding short
position. Thus, regardless of US Dollar rate changes, bank is fully protected, offering
customer protection as well. Thus, 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 deposittaking 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.
STRATEGIZING 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 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
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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. Even plain vanilla deposits need to be priced and priced
by timeframe. 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 must be 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 bands. 1-14 days, 15-days to 1 month, 1 month to 2
months etc. is an example. This organization is termed 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 analyze. Since
all products are mapped, assets represent all inflows and liabilities represent all
outflows. Thus gaps in each time bucket are analyzed. Regulators specify use of
percentage of tolerance for gaps. Practical bankers use an absolute amount. us, as
long as gap remains within tolerance, then it is deemed zero. Thus, the statement in
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the beginning that zero gap is impractical and not desired either. Banks funding or
lending gaps may be very deliberate.
Procedures for Reducing Exposure to Rising Rates (Closing a Negative Gap):

During a period of climbing interest rates, a credit union which is funding its long
term loans with short term deposits (negative gap) will experience rising financing
costs as its deposits float at increasingly high rates. In order reduce this exposure,
the following procedures may be applied to shorten the term of assets and lengthen
the term of liabilities:
Price products so that favorable rates encourage shorter maturities for loans and
longer maturities for deposits. Unfavorable rates should be used to discourage
loan/deposit terms that will enlarge the negative gap.
Where pricing policy will not stem demand for longer term, fixed rate assets,
restrict the availability of fixed rate loans.
Change portfolio mix in favor of variable rate loans. Promote variable rate
consumer loans over fixed rate mortgages. Consumer or commercial loans earn a
higher yield and can be matched against variable rate deposits.
Market/promote products which will close the gap position. Recommended
methods of promoting products include advertisements, in-branch posters and
contest prizes. Inform staff of their priority to increase certain product volumes
through cross selling efforts.
Where new business is not available to correct the gap position, encourage the
conversion of maturities in the existing portfolio. Allow members to negotiate in midterm an extended maturity for fixed rate deposits, or convert closed fixed rate loans
to open loans to encourage prepayment.
Consider selling a portion of the fixed rate mortgage portfolio to other industry
players. Such an arrangement allows ongoing member contact, the correction of an
unfavorable mismatch and the option to earn a return for continuing service.
Procedures for Reducing Exposure to Falling Rates (Closing a Positive Gap):
He same procedures as those described above may be used to reduce exposure to
falling rates (close a positive gap), except that the opposite tactics should be
employed. In an environment of falling interest rates, a credit union which is funding
short-term loans with long-term deposits will experience shrinking revenues and
financial margin as its loan interest income falls while deposit interest expense
remains fixed. In brief, the following approaches are recommended to reduce
exposure to falling interest rate (close a positive gap):
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Price products to dampen demand for variable rate loans and fixed rate term
deposits.
where pricing does not stem demand, restrict funds available for variable rate
loans.
Change portfolio mix in favour of fixed rate mortgages.
Market and promote products which close the gap.
Allow members to extend mortgage terms at current fixed rates.
Create incentives for members to cash term deposits early.
Invest excess liquidity of the investment portfolio into longer term vehicles.
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. tolerance to limits of
cost to close is defined as a measure of structural liquidity risk and this is used for
control.
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 should address all issues
concerning the bank, all policies should be clearly explained to all members of board,
apart from ALCO and these must be documented. Proper revisions to this document,
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a quarterly review needs to be organized as well as parameters may be changing

due to change in situations.
Understanding of complexities:
Many people in a bank need to understand risk measurements and risk mitigation
procedures. Measurement of risk is a fairly simple phenomenon and does go on
regardless. Formalization of understanding, especially at a top level, will be helpful
as it would help in decision making.
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 may not be available at all times in requisite format. It must be remembered
that many data items are assumptions and gaps must be measured in perspective.
There was a case of a manual branch of a bank that was closed for 6 months in a
year due to inclement weather and was largely inaccessible. As data may not be
obtained from this branch for 6 months, appropriate assumptions have to be made in
any event. The argument is that for all other purposes, assumptions are being made.
Sensible options need to be chosen and manual branch without computer was an
example. However, in modern banking, it is mapping of models to zero coupon
bonds that are an issue. Once again, arguments are that this should exist within the
bank.
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Unrealistic goals:
An ALCO secretary was seen desperately trying to tweak with parameters to show
less gaps in liquidity reports. A zero gap is not practical. Returns are expected for
taking risks. Banks assume market and credit risk and hence they make returns.
ALCOs job is to correctly determine positions and put in place appropriate remedial
measures using appropriate risks. It is not to show things as good when they are not.
In any event, market risks and credit risks are not the only causes for failure, as
evidenced by failures in the last decade.
INFORMATION TECHNOLOGY AND ASSET-LIABILITY MANAGEMENT
Many of the new private sector banks and some of the non-banking financial
companies have gone in for complete computerization of their branch network and
have also integrated their treasury, forex, and lending segments. The information
technology initiatives of these institutions provide significant advantage to them in
asset-liability management since it facilitates faster flow of information, which is
accurate and reliable. The electronic fund transfer system as well as demat holding
of securities also significantly alters mechanisms of implementing asset-liability
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management because trading, transaction, and holding costs get reduced.

Simulation models are relatively easier to consider in the context of networking and
also computing powers. The open architecture, which is evolving in the financial
system, facilitates cross-bank initiatives in asset-liability management to reduce
aggregate unit cost. his would prove as a reliable risk reduction mechanism. In other
words, the boundaries of asset-liability management architecture itself is changing
because of substantial changes brought about by information technology, and to that
extent the operations managers are provided with multiple possibilities which were
not earlier available in the context of large numbers of branch networks and
associated problems of information collection, storage, and retrieval. In the Indian
context, asset-liability management refers to the management of deposits, credit,
investments, borrowing, forex reserves and capital, keeping in mind the capital
adequacy norms laid down by the regulatory authorities. Information technology can
facilitate decisions on the following issues:
Estimating the main sources of funds like core deposits, certificates of deposits,
and call borrowings.
Reducing the gap between rate sensitive assets and rate sensitive liabilities,
given a certain level of risk.
Information is the key to the ALM process. Considering the large network of
branches and the lack of an adequate system to collect information required for ALM
which analyses information on the basis of residual maturity and behavioral pattern it
will take time for banks in the present state to get the requisite information. The
problem of ALM needs to be addressed by following an ABC approach i.e. analyzing
the behaviour of asset and liability products in the top branches accounting for
significant business and then making rational assumptions about the way in which
assets and liabilities would behave in other branches. In respect of foreign
exchange, investment portfolio and money market operations, in view of the
centralized nature of the functions, it would be much easier to collect reliable
information
ASSET - LIABILITY MANAGEMENT SYSTEM IN BANKS GUIDELINES
Over the last few years the Indian financial markets have witnessed wide ranging
changes at fast pace. Intense competition for business involving both the assets and
liabilities, together with increasing volatility in the domestic interest rates as well as
foreign exchange rates, has brought pressure on the management of banks to
maintain a good balance among spreads, profitability and long-term viability. These
pressures call for structured and comprehensive measures and not just ad hoc
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action. The Management of banks has to base their business decisions on a

dynamic and integrated risk management system and process, driven by corporate
strategy. Banks are exposed to several major risks in the course of their business
-credit risk, interest rate risk, foreign exchange risk, equity / commodity price risk,
liquidity risk and operational risks. this note lays down broad guidelines in respect of
interest rate and liquidity risks management systems in banks which form part of the
Asset-Liability Management (ALM) function. The initial focus of the ALM function
would be to enforce the risk management discipline viz. managing business after
assessing the risks involved. The objective of good risk management programmes
should be that these programmes will evolve into a strategic tool for bank
management.
ASSET-LIABILITY MANAGEMENT DECISIONS IN

PRIVATE BANKING
Working from the observation that the contribution of asset-liability management

techniques developed for institutional investors is not yet familiar within private
banking, a new study from the EDHEC Risk and Asset Management Research
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Centre, entitled Asset-Liability Management Decisions in Private Banking shows

the expected benefits of a transposition of that kind.
According to the authors of the study, Nol Amenc, Lionel Martellini and Volker
Ziemann, asset-liability management represents a genuine means of adding value to
private banking that has not been sufficiently explored to date. Within the framework
of private financial management offerings, personal wealth managers tend to confine
their clients to mandates that are only differentiated through their level of volatility,
without the clients personal wealth constraints and objectives being genuinely taken
into account in order to determine the overall strategic asset allocation. In that sense,
private wealth management is not sufficiently different from the management of a
diversified or profiled mutual fund.
It is not so much the risk-adjusted performance of a fund or even of a given asset
class that is the determining factor in including it in the clients personal wealth, but
its capacity to match the clients liabilities. The clients liability constraints (horizon,
nature, amount and certainty of future cash flows that will be received and invested;
their projects, which could have varying exposures to risk factors, whether it involves
real estate or inflation) must be taken into account in managing their assets; which
private bankers rarely do when they put together their clients overall strategic asset
allocation.
In the end, it is not so much the short-term risk represented by the volatility of the
assets that is the determining element in taking an individuals risk aversion into
account, but the probability or the expectation of the individuals long-term financial
objectives not being achieved.
Taking these elements into account leads to asset allocations that are very different
from the allocation provided by an optimization carried out in a static mean-variance
or mean-VaR framework, as performed by the vast majority of private wealth
managers.
ASSET LIABILITY MANAGEMENT SYSTEM
ALM is a risk management tool that helps a bank's management take investment /
disinvestment decisions, maintain the required statutory liquidity ratio (SLR), credit
reserve ratio (CRR) and other ratios as per Reserve Bank of India (RBI) guidelines. It
generates the SLP / IRS / MAP / SIR reports and supports risk management
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modules like graphical analysis, data analysis and interest rate simulation. Basically,
the Asset Liability Management System consists of seven 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. he 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 change,
this function can be used. For example, bucket codes defined by RBI for SLP are:
o 1 to 14 days
o 15 to 28 days
o 29 days and up to 3 months
o Over 3 months and up to 6 months
o Over 1 year and up to 2 years
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o Over 2 years and up to 5 years

o Over 5 years
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. RBI
code mapping: This function lets the user map ALM account codes with the RBI
account codes.
Client code mapping: This function lets the user map ALM account codes with the
client account codes.
Data process: This module allows the user to upload the data into the system
manually or through a flat file for:
O Trial balance
o Residual accounts
o Parameterized accounts
o 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: Generates various reports:
o Structural liquidity profile (SLP)
o Interest rate sensitivity (IRS)
o Maturity and position (MAP)
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 change,
this function can be used. For example, bucket codes defined by RBI for SLP are:
o 1 to 14 days
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o 15 to 28 days
o 29 days and up to 3 months
o Over 1 year and up to 2 years
o Over 2 years and up to 5 years
o Over 5 years
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.
ASSET-LIABILITY MISMATCH
In finance, an assetliability mismatch occurs when the financial terms of an

institution's assets and liabilities do not correspond. Several types of mismatches are
possible. For example, a bank that chose to borrow entirely in US dollars and lend in
Russian rubles would have a significant currency mismatch: if the value of the ruble
were to fall dramatically, the bank would lose money. In extreme cases, such
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movements in the value of the assets and liabilities could lead to bankruptcy, liquidity
problems and wealth transfer. As another example, a bank could have substantial
long-term assets (such as fixed-rate mortgages) but short-term liabilities, such as
deposits.
This is sometimes called a maturity mismatch, which can be measured by the
duration gap. Alternatively, a bank could have all of its liabilities as floating interest
rate bonds, but assets in fixed rate instruments. Mismatches are handled by asset
liability management. Assetliability mismatches are important to insurance
companies and various pension plans, which may have long-term liabilities
(promises to pay the insured or pension plan participants) that must be backed by
assets. Choosing assets that are appropriately matched to their financial obligations
is therefore an important part of their long-term strategy. Few companies or financial
institutions have perfect matches between their assets and liabilities. In particular,
the mismatch between the maturities of banks' deposits and loans makes banks
susceptible to bank runs.
On the other hand, 'controlled' mismatch, such as between short-term deposits and
somewhat longer-term, higher-interest loans to customers is central to many
financial institutions' business model. Assetliability mismatches can be controlled,
mitigated or hedged.
EMERGING ISSUES IN THE INDIAN CONTEXT
With the onset of liberalization, Indian banks are now more exposed to uncertainty
and to global competition. This makes it imperative to have proper asset-liability
management system in place. The following points bring out the reasons as to why
asset-liability management is necessary in the Indian context.
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1. In the context of a bank, asset-liability management refers to the process of

managing the net interest margin within a given level of risk. Net Interest Margin=Net
interest income/Average earning assets Net interest margin can be viewed as the
spread on earning assets. Efficient management of net interest margin becomes
essential as the basic objective of banks is to maximize income while reducing their
exposure to risk.
2. Several banks have inadequate and inefficient management system that have to
be altered so as to ensure that the banks are sufficiently liquid.
3. An increasing proportions of investments by banks is being recorded on a marketto-market basis and as such large portion of the investment portfolio s exposed to
market risks. Countering the adverse impact of these changes is possible only
through efficient asset-liability management techniques.
4. As the focus on the net interest margin has increased over the years, there is an
increasing possibility that the risk arising out of exposure to interest rate volatility will
be built into the capital adequacy norms specified by the regulatory authorities. This,
in turn, will require efficient asset-liability management practices.
WHERE THE ASSET-LIABILITY MANAGEMENT IS GOING
Changes in the availability of computers and the vast increase in their calculation
power have led to ongoing refinements in the way risk is measured and managed.
The biggest open issues on the risk measurement side are about the modeling of
behavior-either the clients or the banks. The following are three key topics where
the results can significantly affect the risk measure ad where quantification is still
difficult.
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(a) Prepayment: Much work has been done to describe the prepayment of
mortgages. here is a wide range of methodologies in use, all the strength and
shortcoming and all demonstrating room for improvement.
(b) Average life of non-maturity deposits: Again, a lot of work has been done to try to
describe the balance behavior of savings and checking accounts. While there are
several distinct methodologies, no clear favorite emerges. There is no definitive
answer as to the average life of a deposit.
(c) Pricing strategies: The rates that banks pay on retail products still move at the
discretion of the banks and in response to the factors other than moves in market
rates. On the risk management side, understanding and quantifying performance
remains an open issue. Funds transfer pricing systems allow some quantification of
return from the interest rate but are not designed to describe how good that
performance was. he next step in performance measurement will be to attempt to
quantify returns in terms of the amount of risk taken. The ideas are out there, in
various approaches to risk-adjusted performance measurement systems, but they
are still implemented by a minority of institutions.
All of these issues are about refinements to the basic approaches of asset-liability
management. They do not represent radical departures from the basic frameworks of
risk-measurement and risk-management. The process of asset-liability management
will continue to refine itself, but the framework is not going to change without a big
push from somewhere else.
CHALLENGES FACED BY ASSET LIABILITY MANAGEMENT
The Asset Liability Management function's main challenge lies in measuring the
sensitivity of risk exposures to any change in one or more factors, and quantifying
the impact of "unexpected" movements in one or more factors. Other key challenges
include:
Collating and cleaning product, customer, market, and competitor data;
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Capturing the quality, valuation and risk-based performance of the balance sheet;
Modelling the financial characteristics and event probabilities of non-maturity
assets and liabilities such as customer deposits, credit cards, investment rollovers;
Modelling the potential growth and evolution of the balance sheet in response to
business development strategies, customer behavior, competitors and other external
factors.
Asset Liability Management is a broad field with various specialties. Our services
range from setting up the entire Asset Liability Management process to providing
support in specific areas such as:
Defining, sourcing and maintaining Asset Liability Management data definition
requirements;
Defining and developing Asset Liability Management models to calculate the risk
and return impact of new products or new markets, or measure the impact of new
regulations;
Defining appropriate Asset Liability Management governance and providing
guidance to the Asset Liability Management committee on directing the balance
sheet, risk and return;
Building an integrated modelling process that captures credit, market, and liquidity
risk implications on earnings, value and the overall balance sheet condition;
Reviewing and building behavioural models and implementation for cards,
deposits or overall business areas this includes supporting statistical studies and
analysis;
Designing and implementing stochastic and deterministic modelling for earnings,
valuation, option adjusted spread, Value at Risk, cost to close;
Conducting comprehensive front to back review and implementation of all
supporting measurement, governance, process, system and controls for foreign
exchange, interest rate risk, credit integration, capital management, liquidity and
overall integrated risk management.
CONCLUSION
It is important to note that the conglomerate approach to financial institutions, which

is increasingly becoming popular in the developed markets, could be replicated in
Indian situations. This implies that the distinction between commercial banks and the
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term lending institutions could become blurred. It is also possible that the same
institution involves itself in short term and long term lending borrowing activities like
mutual funds, insurance and pension funds. In such a situation, the strategy for the
asset-liability management becomes more challenging because one has to adopt a
modular approach in terms of meeting asset-liability management requirements of
different decision and product lines. But it also provides opportunities of
diversification across activities that could facilitate risk management on an enhanced
footing.
The success of ALM, Risk Management and Basel Accord introduced by BIS
depends on the efficiency of the management of assets and liabilities. Hence these
days without proper management of assets and liabilities, the survival is at stake. A
banks liabilities include deposits, borrowings and capital. On the other side of the
balance sheets are assets which are loans of various types which banks make tithe
customer for various purposes. To view the two sides of banks balance sheet as
completely integrated units has an intuitive appeal. But the nature, profitability and
risk of constituents of both sides should be similar. The structure of banks. Balance
sheet has direct implications on profitability of banks especially in terms of Net
Interest Margin (NIM). So it is absolute necessary to maintain compatible assetliability structure to maintain liquidity, improve profitability and manage risk under
acceptable limits.
BIBLIOGRAPHY
http://rbidocs.rbi.org.in/rdocs/PressRelease/PDFs/3204.pdf
http://www.cab.org.in/Lists/Knowledge%20Bank/Attachments/106/Assel__liability
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http://www.google.co.in/url?
sa=t&rct=j&q=asset+liability+management&source=web&cd
http://www.frsglobal.com/solutions/solutionsalm.html
http://www.riskglossary.com/link/asset_liability_management.htm
INDEX
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Asset Liability Management in Banks

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Asset/Liability Management Strategy

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Challenges faced by ALM