AssetLiabilityManagement

Banks hold different categories of assets and liabilities with different maturities carrying different
interestrates.Thebanksabilityinmatchingthisassetandliabilitystructureresultsinimprovingits
returns.Assetliabilitymanagementinvolvesmanagingdifferentriskssuchasinterestraterisk,credit
risk, operational risk, exchange rate risk, market risk, liquidity risk, contingency risk and treasury
managementrisk.
Variationsininterestrateswillimpactthevalueofassetsandliabilitiesthatabankholds.Therefore
theyneedtodevisetoolsandtechniquestohandletheimpactofthesechanges.Interestraterisk
management helps in maximizing bank profits and reduces losses and protects bank assets. The
nature of banks having a smaller capital base compared to the larger asset base makes banks
vulnerabletocapitalerosionduetoreductioninvalueofassets.
Bankbalancesheetbeforecapitalerosion
Liabilities

Assets

Capital

20000

Reserves

85000

Borrowings

10000

Advances

588000

Shorttermdeposits

550000

Investments

100000

Longtermdeposits

200000

FixedAssets

7000

Total

780000

Total

780000

Bank balance sheet after capital erosion on account of 2% value reduction in advances shows a
58.8%reductionincapital.
Liabilities
Capital
Borrowings

Assets
8240

Reserves

85000

10000

Advances

576240

Shorttermdeposits

550000

Investments

100000

Longtermdeposits

200000

FixedAssets

7000

Total

768240

Total

768240

There are several models of risk management through asset liability management. They are asset
models,liabilitymodels,randomnessmodels,multidimensionalmodelsandcomputeraidedasset

liabilitymanagement(CALM)models.Assetmodelsandliabilitiesmodelsfocusononeaspectofthe
balance sheet. The randomness model is based on selected criteria that impact the bank
performance.Multidimensionalmodelslookatimpactofselectedvariablesonseveralindependent
variables.TheCALMmodelsarecomprehensiveandaimatdynamicassetliabilitymanagement.
In managing risks banks need to focus attention on volume, mix, maturity, rate sensitivity, quality
and liquidity and acceptable risk reward ratio. The parameters for ALM are net interest margin,
marketvalueofequityandeconomicequityratio.
ReserveBankofIndiahasprovidedguidelinesintermsofassetliabilitymanagement.Thetraditional
approach focuses on operational limits on credit, loan provisioning, portfolio diversification and
collateralization. The innovative methods suggested include loan securitization, capital adequacy
andderivativeproducts.
For successful risk management by banks, well developed money market, trading in repo
transactions,forwardtrading,underwritingfacilitiesandderivativemarketsareessential.
GapAnalysis
Thetechniqueusedbybankstoanalyzetheimpactofinterestratechangesontheassets,liabilities
and net worth. Gap is the difference between rate sensitive asset and rate sensitive liabilities. A
negativegapisassociatedwithincreaseininterestratesandapositivegapisassociatedwithdecline
ininterestrates.Estimatedlossiscomputedwithreferencetovaluechangewithineachtimebucket
andaggregatedifferencebetweenassetsandliabilities.
Liabilities

Assets

RateSensitiveLiabilities

RateSensitiveAssets

FixedRateLiabilities

FixedRateAssets

Total

Total

Apositivefundsgapshowsfinancingofratesensitiveassetsbyfixedrateliabilities.Anegativefunds
gapontheotherhandshowsfixedrateassetsfinancedbyratesensitiveliabilities.
Example
Liabilities

Assets

RateSensitiveLiabilities

RateSensitiveAssets

Shorttermdeposits

550000

Advances

145000

FixedRateLiabilities
Borrowings
Longtermdeposits

Investments
10000
200000

Reserves

Total

20000
780000

85000

FixedRateAssets
Advances

Capital

100000

FixedAssets
Total

443000
7000
780000

Liabilities

Assets

RateSensitiveLiabilities

RateSensitiveAssets

Shorttermdeposits

550000

Advances

145000

Investments

100000

Reserves

85000

FixedRateAssets
Advances
FixedRateLiabilities
Borrowings
Longtermdeposits
Capital
Total

220000

FixedRateAssets
10000

Advances

223000

200000
20000
780000

FixedAssets
Total

7000
780000

Total Rate Sensitive Assets (RSA) = 330000

Total Rate Sensitive Liabilities (RSL) = 550000
Funds Gap = 220000 (Negative Gap)

Aconservativebankmaintainsapositivegapandgainsfromincreaseininterestrate.Anaggressive
bank maintains a negative gap and gains from decrease in interest rate. The net interest income
likely to affect the bank due to changing interest rate scenarios can be computed by multiplying
changeinratewiththegap.
Otherwaysofrepresentinggapincluderelativegapandgapratio.Whenabankhasapositivegapa
possible management action at times of rising interest rates would be to increase rate sensitive
assets or reduce rate sensitive liabilities. Another possible action is to extend liability maturity or

shorten asset maturities. If on the other hand interest rates are falling, a reverse action will be
initiated.
DurationAnalysis
Durationanalysisaimsatmaximizingmarketvalueofequity.Durationiscomputedtakingweighted
average of cash flows of an instrument discounted to present time. Duration gap is computed
subtractingweightedliabilitiesdurationfromassetduration.Theweightsarecomputedbydividing
totalliabilitiesbytotalassets.
Duration analysis assumes precise knowledge of duration of assets and liabilities, market value of
assets,aflatinterestratestructure,noimpactofconvexityonvaluationandaparallelshiftinthe
changeofinterestrates.
Computationofdurationgap

Assets

Liabilities

T Bill Investment

Certificate of Deposit

1 year
Loan 2 year

7%

30

1 year

6%

50

10%

70

3 Year Time Deposit 8%

40

Capital

10

100

100

When rates increase by 2%

Assets

TBill: 32.70
(1+0.09)

Discounted
CashFlows

30.00

Loan:7.00=6.25

67.63

(1+0.12)
77.00

=61.38

(1+0.12)2
AssetValue

97.63

Liabilities

1 Year CD

Discounted Cash Flows

54.00

50.00

(1 + 0.08)
3 Year TD

3.60

= 3.24

38.04

(1 + 0.11)
=

3.60

= 2.92

(1 + 0.11)2
=

43.60

= 31.88

(1 + 0.11)3
Total Liabilities

88.04

Market Value of Bank Capital (97.63 88.04)

9.59

Additional Income - (-20 x 0.02)

0.40

Decline in Capital Value of Bank (10 9.59 0.40)

0.01

Book Value of Bank Capital

10.00

Assets

Duration
n

TBill:

1.000

Loan:

1.908

WeighteedAveraged
duration0.30
0x1.000

1.635

0.70x1.908

onequity
Impacto
Equity

Value

0.9

0.02

0.063

MacauleysDuration

0.057

DeclineinEquityValue(DurationGap)

0.010

Summaryofimpactofdurationgaponchanginginterestratescenarioscanbestatedasfollows.
Duration
Gap

Interest
rate
Change

Assets

Liabilities

Equity

Positive

Increase

Decrease

>

Decrease

Decrease

Positive

Decrease

Increase

>

Increase

Increase

Negative

Increase

Decrease

<

Decrease

Increase

Negative

Decrease

Increase

<

Increase

Decrease

Zero

Increase

Decrease

Decrease

No
change

Zero

Decrease

Increase

Increase

No
change

Immunizationistheprocessofachievingazerodurationgap.Immunizationofbankportfoliois
optimumwhenthegainfromthehigherreinvestmentrateisoffsetbycapitallossandthechangein
capitalisinsensitivetochangesininterestratefluctuations.
DerivativesinALM
Financialderivativeinstrumentsareinstrumentsofriskmanagementusedbybanksforhedging
expectedvariationsinreturnsorvalues.Someofthederivativeinstrumentsusedbybankstohedge
theirinterestrateriskareforwardrateagreements,futures,options,swaps,caps,floorsandcollars.
Forwardrateagreementsarecontractswhereabankanticipatingincreaseordecreaseininterest
ratesentersintoacontractwithcounterpartyforexchangeofvaluesatpredeterminedrates.
Futuresaresimilarcontractswherebankstakepositiontosettlecontractsatcurrentratesona
futuredate.Thesecontractsaremarkedtomarketandareforafixedduration.Optionsare
contractsthatprovidearighttobuyorsellatanagreedrateaninstrumentonafuturedate.Caps,
floorsandcollarsprovidetheupperandlowerlimitsforinterestratefluctuationswhichtriggersa
contractonthebanks.Swapsaimatexchangeoffixedrateinstrumentstofluctuatingrate
instrumentsatpredeterminedratesonafuturedate.

Swaps

HedgeP
Positions

Hedge: Long Futures

s:
en rates fallss
loss whe

Hed
dge: Short Fu
utures:
losss when rates rise

FuturesProfile

A) Profit or losss for buyerr of futures

futures

B) Profit
P
or losss for seller of

OptionssProfile

buyerofcall
A)Profittorlossforb

optionaandbuyeroffutures

B)Profitorlossforbuyerofputo
option
option
nandsellero
offutures

Caps

Floors

Collar

Interestrrateriskman
nagement
Thestrategiesadopttedbybanksstomanage interestrateerisksmayb
bebroadlyclaassifiedintotwo
categoriies.Thefirstistherearraangementof
f balancesheeetthatinclu
udesduration
ngapmanaggement.
Theseco
ondistheofffbalancesheetadjustmentthroughinstrumentsssuchasinteerestratesw
wap,
hedgingwithfinanciialfutures,in
nsuranceand
drisktransfeer.

Someofthecausesforriskfromoffbalancesheetactivitiesincludecontingentliabilities,guarantees,
standbylettersofcredit,loancommitmentsandnoteissuefacilitiesgivenbybanks.Securitizationof
loanwhereinadebtinstrumentisissuedbyabankbasedonexpectedrevenuesfromadefinedpool
ofloansisastrategyusedbybankstotransferloanriskstomarket.
Hedging

ExampleInterestrateforwardcontract

PurchaseofTBillswithamaturityofoneyear.

Advantages

Riskofincreasedinterestrateisreduced

FlexibilitycanbeincorporatedinthecontractiftheyaretradedintheOverThe
Counter(OTC)market.

Disadvantages

OTCcontractshavelessliquidity

Defaultrisktothebank

Questions

1.
2.
3.
4.
5.
6.
7.
8.

What is asset liability management?

Explain the steps in asset liability management process.
What is gap analysis? How is it performed?
What is duration analysis? Explain the methodology.
How is interest rate risk managed by banks?
What are derivatives?
How are derivatives used by banks for interest rate risk management?
What are off balance sheet items? What type of risks banks face in holding off
balance sheet items?
9. What are the assumptions behind duration analysis?
10. Discuss the technique of interest rate risk management used by bank.
11. Determine the gap for a bank with an asset sensitive value of 49 crore and liability
sensitive value of 120 core.
12. Determine if a bank is conservative or aggressive if it has a positive gap position.

13. Determine the change in interest rate income if gap is 36 crore and expected change in
interest rate is 50 basis points.
14. Determine the relative gap if total assets of a bank are 1000 crore, rate sensitive assets
are 75 crore and rate sensitive liabilities are 65 crore.
15. Determine the gap ratio if rate sensitive assets of a bank are 500 crore and rate
sensitive liabilities are 750 crore.