Asset Liability Management

in
Commercial Banks

ALM(CB)

asit
ASSET- LIABILITY MANAGEMENT

Asit Mohanty
 Outline
• Objectives of ALM
• Scope of ALM
• ALM Products & ALM as Career Option
• ALM Instruments
• Interest Risk Management
• Pricing of Deposits
• Earning at Risk (NII)
• Hedging of Interest Rate Risk
• Loan Pricing ( Base Rate + MCLR)
• Cost of Equity and RAROC
• Modified Duration
• Market Value of Equity
• Approaches to Value at Risk
• Prepayment Model
• Liquidity Risk ( Static and Dynamic)
• Projection of Balance Sheet
• ALM Ratio Analysis
• Asset Backed Securities (ABS) and Mortgage
Backed Securities(MBS)
• Basel III and ALM
• Hands On (Proof of Concept)
• New Generation ALM
• Interest Rate Forecasting Techniques
• ALM & Economics of Securitization of Assets
• Valuation of Banks
• De-monetisation and ALM
• Hands On (Proof of Concept)
 OBJECTIVES OF ALM
• TO MANAGE THE LIQUIDITY OF A BANK EFFICIENTLY
– Through the Outflow /Inflow of the existing liability / asset
– Creation of New Business

• TO MANAGE THE INTEREST RATE RISK

– BY PROTECTING NII / NIM (SHORT TERM GOAL)
NET INTEREST INCOME IS THE EXCESS OF INTEREST EARNINGS OVER INTEREST EXPENSES
NIM IS THE RATIO OF NII TO TOTAL INTEREST BEARING ASSETS
Therefore, to decide about the BENCHMARK PLR

• TO IMPROVE THE NETWORTH OF A BANK (LONG TERM GOAL)

– Compute Market Value of Equity (MVE)

– Compute Economic Value Addition (EVA)

• Deposit and Loan Pricing

• Securitization
 Scope of ALM
Liquidity Risk Interest Rate Risk
Earnings/MVE
•Interest Rate Sensitive Analysis
• Liquidity Profile of Position of Assets & EaR Analysis
Assets & Liabilities Liabilities MVE Analysis
across time Buckets EVA Analysis
•Modified Duration at
• Static Liquidity Ratio Product Level
Analysis
•Modified Duration Gap of
•Dynamic Liquidity the Balance Sheet Value at Risk
Position Both Asset &
•Risk Based Pricing of
•Liquidity Index Loans Liability

•Cash flow model for •Mean Reversion Interest

Perpetual products Rate Model for forecasting
of Interest Rate
•Pre Payment
Models…prepayment •Monte Carlo Simulation Valuation of
rate of the Retail for Interest Rate Risk Banks
Mortgage Loan
NPV Method to measure
• Non Market Related Off Interest Rate Risk in
Balance Sheet Model Scenario Manager
Banking Book

•Worst Case
& Best Case
ALM Reporting Scenario
 ALM Process Flow

Common ALM Output

Inputs ALM Computations

(CBS) (Cash Flow Engine)

Simulations
Periodic

Cash Flow Engine IRR LR NII

Contractual Positions
Contractual Simulations
IAS 39 Daily Liquidity
Perpetual
OBS Periodic
Behavioral Models
IRR LR NII

MD ALM MVE
Gap Ratios EaR
Scenario Manager

Projected Balance
Sheet
Scenarios
Projected P&L

ALM Process Flow

3 Tier hierarchy for ALM Process Flow
 IBM - Algo Asset Liability Management
• Algo Asset Liability Management features
include:
• Sophisticated analytics and reporting tools help assess
earning sensitivity, future market valuation and liquidity risk.
• Comprehensive regulatory compliance supports Basel III,
IAS 39 and FAS 133 international accounting rules and more.
• Scenario-based Optimizer enables risk-informed assessment
of the trade-off between earnings and values.
• Comprehensive asset and liabilities coverage spans off-
balance sheet items, with measures such as NIM and FTP.
• Internal limits support enables forecasts of future business
to take into account corporate limits for liquidity and
hedging policies.
 Asset Liability Management
Moody’s Analytics

• Accurate Balance Sheet Risk Management

Oracle Financial Services Asset-Liability Management

• Analyze and forecast interest

rate risk through deterministic
and stochastic simulation
results
• Monitor Liquidity Gaps,
Funding Concentrations,
Marketable Assets and
Liquidity Ratios on a daily
basis
• Access to granular and
actionable ALM insight
directly within operational processes
• Sungard ALM
• Kamakura Risk Manager (KRM)
• FERMAT ALM
Piper MeasuRisk
TruView Askari
Fermat ALM Fermat
RV Limits MKIRisk
FXAT Alphametrics
Findur Asset Liability Management OpenLink
IPS-Sendero A/L Systems,
Asset/Liability Budget Management IPS-Sendero
(ALBUM)
BARRA TotalRisk (TM) for Asset
BARRA, Inc.
Management
KRM-ni: Net income simulation,
The Kamakura
KRM-tp: Transfer pricing, KRM-dc:
Corporation
Deposit valuation
RiskPro(TM) Value Exposure
IRIS integrated risk
Analysis, RiskPro(TM) Funds
management ag
Transfer Pricing FTP
BancWare Convergence, BancWare SunGard Trading
Insight and Risk Systems
Risk Trade RiskBox.com Ltd
• http://www.bobsguide.com/guide/asset-and-
liability-management-solutions-2.html
 Introduction to ALM… ALM Instruments…Global Practices
• There are two Primary Risks associated with ALM…Interest Rate
Risk and Liquidity Risk

• Interest Risk arises from the possibility that profits will change if
rate of interest change.

• The Liquidity Risk arises from the possibility of losses due to bank
having insufficient/surplus cash on hand to pay customers.

• ALM is different from management of Market Risk because Market

risk deal with trading operation and ALM Positions are relatively
illiquid…..takes care of Banking Book

• After origination, the assets and liabilities are typically held by the
bank until they mature, although it is becoming increasingly
common to bundle banking products such as loans into
securitization and sell or trade them with other banks.
• http://arcindia.co.in/
 Introduction to ALM… ALM Instruments..Contd
U.S Saving & Loan Crises
• The best illustration of ALM Risks is given by U.S (S&L) crisis
(Thrift and Building Society)
• The Commercial Banks in US were mandated by FED… to take
Retail deposits at 4% and can lend to 30 year mortgage loans
at 8%.....the rate are fixed and regulated by the FED. This gives
4% spread.
• In 1980, FED deregulated the rate of interest…as a result the
short term rate rose to 16%....many depositors withdrew their
fund…..re priced at higher rate……however loans were locked
at 8% for 30 years….
• The spread became negative…..most of the Banks went
Bankrupt
• By the end of 1982, massive losses had driven the tangible
capital of the industry down to 0.5% of total assets
• This ALM Risk is combination of Interest Risk
and Liquidity Risk.

• The measurement of ALM Risk is made more

difficult than the management of a simple
bond portfolio as the indeterminate
maturities of assets and liabilities.

• The indeterminate maturities of Assets and

Liabilities leads to uncertainty of as to when
borrower will make or the depositors ask for
payment
 ALM Instruments….Contd

• Therefore, the ALM positions makes to measure the risk in the banking
book as well as trading Book.

• ALM products are mainly driven by the customer behavior…such as

mortgages and deposits have many implicit or embedded options that
makes the values dependent not only on market rates but also on
customer behavior.

• For Example, the depositors can any time withdraw their deposits and
borrower can prepay the loans…if the borrower find a cheaper rate else
where.
 Introduction to ALM… ALM Instruments..Contd
Global Practice

• Assets
– Retail Personal Loans
– Retail Mortgages
– Credit Card Receivables
– Commercial Loans
– Long Term Investments
– Traded Bonds
– Derivatives…Off Balance Sheet Item

• Liabilities
– Retail Checking accounts
– Retail Saving Accounts
– Retail fixed Deposits accounts
– Deposits from Commercial Customers
– Bonds issued by Bank
Financial Ratio Analysis of Banks
 Important Financial Ratios of Banks
(% growth) Business of the Bank

Total Loans & Advances + Total Deposits = Sh 3 + Sh 9

 Important Financial Ratios of Banks
CD Ratio……
• It is the proportion of loan-assets created by banks from the deposits
received. The higher the ratio, the higher the loan-assets created from
deposits.
• high credit-deposit ratio could lead to a rise in interest rates….as demand
for loan will increase

• The higher the ratio, the more the bank is relying on borrowed deposits
rather than own funds
 Important Financial Ratios of Banks
1.Growth in Risk Weighted Assets (RWA)

RWAs at the current year end - RWAs at the last year end x100
RWAs at Last Year end
• Any disproportionate increase in RWAs vis-à-vis the growth of total assets
signifies the bank's appetite for assuming more risks for maximizing
returns.
• A critical analysis of the composition of risk-weighted assets is called for.
 Important Financial Ratios of Banks
2.Capital to Risk Weighted Asset Ratio (CRAR)….
Risk Weighted Assets ratio

3. Core capital Adequacy Ratio………..

Tier I Capital
Risk Weighted Assets
The ratio should be more than T II Ratio
4.Ratio of debt to Tier I capital

Debt (deposits, borrowings, subordinated debt

and hybrid capital)
Tier I capital
If the ratio is lower than 20(ceiling) the bank
considered as a low risk bank
 Important Financial Ratios of Banks
5. Capital Coverage ratio
Eligible (TI +T2) - net NPA
Total RW Assets

• Expressed in terms of percentage, this ratio shows the ability of a bank to withstand
losses in the value of its assets. The merit of the coverage ratio lies in the fact that it
allows simultaneous monitoring of two important elements, viz., (I) level of non-
performing loans and (ii) equity capital (TI +T2), adverse movements in which have
been found to precede most cases of banking crises.

• Focusing on this ratio is quite important as it allows differentiating between banks,

which may have the same level of non-performing loans but different levels of
capital funds. In the case strong banks, this ratio would be higher and could go as
high as the level of the capital adequacy required (9 to 12 per cent).

• As it declines and comes closer to zero, it shows the declining ability of the bank’s
own resources, to cover for non-performing loans.
 Important Financial Ratios of Banks

6. Adjusted CRAR Ratio (Net of Net NPAs)

Total Eligible Capital – Net NPAs

Risk Weighted Assets – Net NPAs

• The ratio reveals the unimpaired capital i.e., Net of Net NPAs available
within the bank to mitigate potential adverse impacts of credit, market
and operational risks. If the ratio is lower than the prudential level of
9%, the cushion available for absorbing future loss is limited.
 Important Financial Ratios of Banks

7. Equity Multiplier (EM)

Total Assets
Total Equity
• A bank's EM compares assets with equity and large values indicate a large
amount debt financing relative to equity.

8. Ratio of Incremental NPAs to Opening Gross Advances

New accretion to NPAs during the year
Gross standard advances at the beginning of the year
Asset Quality…………
These ratios on Incremental NPAs to Gross Standard Advances would basically reveal
the asset quality of standard advances of banks. These ratios basically reveal the
deterioration of the advances portfolio during the year. Higher ratio indicates the
aggressive loan philosophy or poor asset quality of banks……Default Ratio
 Important Financial Ratios of Banks
9 . Gross/ Net NPAs (including NPAs in Investments) to total Assets
Gross NPAs
Gross Advances

10. Net NPAs…

Net Advances
• These ratios reveal the degree of impairment of assets in the balance sheet

11. Ratio of Net NPAs to Total Equity(Solvency Ratio)

Net NPAs
Total Equity
• Ratio of Net NPAs to Total Equity indicates the equity cover for NPAs. If the ratio is greater
than unity, that particular bank is financing NPAs out of interest paying liabilities. For example
the total Equity of the bank is say Rs 100 and the Net NPAs are at Rs 110. Therefore we may
construe that the bank is funding NPAs worth Rs 10 from its interest bearing liabilities Rs 10.
Therefore the cost fund on this Rs 10 and the income, which could have been earned on this
Rs 10, is a loss for the bank. This sort of funding pattern would adversely affect the
profitability of banks
 Important Financial Ratios of Banks
12. Large Exposures to capital funds (Tier I and Tier II Capital)
if Large Exposures in excess of 10% of capital funds
Capital funds

• At present, banks are not permitted to lend more than 15% / 40%(p 165) of their capital
funds to single…SBL and group….GBL (infrastructure projects upto 20/50%) borrowers,
respectively. However, there is no limit on total exposures in excess of a threshold limit,
say 10% of capital funds. The ratio of Large Exposures to capital funds provides a good
measure of concentration risk. The ratio is a better pointer of future asset quality
problems.
• Another way to measure this risk is to calculate the concentration of top 20 accounts in
the overall credit portfolio of the bank. A concentration of over 40% of Total advance is
considered as high-risk portfolio where as concentration lower than 14% is considered
as low risk exposure.
………..30.49%(p165)….
Concentration of NPA
Concentration of Deposits
20 Large depositors(20)
21 Concentration of advances(20)
 Important Financial Ratios of Banks

13. Return on Assets (ROA)….

Net Profit…
Total Assets..
– ROA is the financial indicator of the efficiency of banks. A lower ROA signifies poor
return on assets or high operating expenses or losses in loan or investment portfolios.
The analysis of ROA may be extended to Profit Margin (PM) and Asset Utilisation (AU)
Ratios to identify the real reason/s for high/poor ROA. (AU*PM)
– High ROA may be due to excessive risk appetite or trading positions
14. Return on Average Equity

Net Profit after tax

Average Total Equity
Equity includes paid-up capital, reserves (excluding revaluation reserves) Free
Reserves The ratio has to be worked out on profit after tax. The ratio above 20% is
considered good and the ratio lower than 10% is considered that the bank is
vulnerable.
 Important Financial Ratios of Banks
24. Profit Margin (PM)
Net Profit
Total Income
• A ratio of profitability calculated as net profit divided by total income. It measures
how much out of every rupee of gross income a bank actually earns as profit.
• A higher profit margin indicates a more profitable bank that has better control
over its costs. Profit margin is displayed as a percentage; a 20% profit margin, for
example, means the bank has a net income of Rs 0.20 for each Rupee of gross
income. If a bank has costs that have increased at a greater rate than gross
income, it leads to a lower profit margin. This is an indication that costs need to be
under better control.
• Imagine a bank has a net income of Rs10 from sales of Rs100, giving it a profit
margin of 10% (Rs10 /Rs100). If in the next year net income rose to Rs15 on sales
of Rs200, its profit margin would fall to 7.5%. So while the bank increased its net
income, it has done so with diminishing profit margins.
• Five additional ratios given in next slides are also needed to assess the profitability
in respect of specific type of expenses and taxes. If these ratios are higher as
compared to their peers the impact is high on the profitability.
 Important Financial Ratios of Banks
25. Assets Utilization (productivity)

Total Income
Total Assets
• The asset productivity depends on the proportion of earning assets to
total assets of earning base of banks. The earnings could be augmented
through efficient asset allocation. The portfolio changes, i.e. investments
or loans are not only induced by changes in environment but also the yield
differential and changing risk profiles.
Total Income
Total RW Assets
 Important Financial Ratios of Banks
15. Return on Risk – Weighted Assets
Net Profit
RW Assets
– The ratio of Return on Assets basically focuses only balance sheet items. Most of the
banks are scouting for off-balance sheet items for fee-based income. This process has
significantly altered the risk profile of banks. Thus, the measure of Return on Risk
Weighted Assets, which captures the off-balance sheet activities of the bank as well
reveal the relationship between the risks and returns. In case the ratio has consistently
been decreasing, it indicates that the bank has not been adequately compensated for
the additional risks assumed. This ratio also recognizes the growing role of fee income
or the differing expense levels in connection with various lines of business.
 Important Financial Ratios of Banks
16. Earning Per Share (EPS)…. Net Profit
No. of Equity Shares
17. P/E Ratio

Stock price……..(How to calculate)

EPS
• The EPS and P/E ratios indicate the appetite of the bank's scrip in the market. The
capital market looks at these ratios very closely. Higher the EPS there will be higher
demand in the public issue market.
• However if the earning is not increasing commensurate to the new capital issue
then the EPS will come down.
• Generally when the PE ratios are high it is considered that the price of the stock is
high. One has to take into account the perception of the market to decide whether
the PE ratio is high or low. Generally the PE ratio of banks is lower than the market
average.
 Important Financial Ratios of Banks
18. Net Interest Income (NII) =Interest Income –Interest Expenses

Net interest income or the interest spread, is defined as the difference between
interest income and interest expenses. Interest spread is an important indicator of
efficiency of banking operations. Although higher the spread it is good for the
bank, a higher spread than its peer may not be sustainable in the long run.
The growth of spread in recent years clearly establishes that banks have not fully
passed on the benefit of falling interest rates to their customers.
19. Net Interest Margin (NIM) = Net Interest Income (NII)
Total Earning Assets(RSA)..WF

NIM is computed by dividing net interest income, by earning assets. Used as an

analytical tool to measure profit margins from the assets deployed.
 Important Financial Ratios of Banks

20. Risk Adjusted Net Interest Margin (RANIM)

= Net Interest Income (NII) – provision for loan losses & investment
Total Earning Assets
Normally, RANIM is a refinement of NIM which factors into provisions made
against losses. The analysis throws open not only the impact of credit risk
but also market risks on the profitability of banks.
21. Total Return on Investments
Coupon income + Capital gain (+) or Capital loss (-) + reinvestment income
Total return on investments, inter-alia, takes into account the coupon yield,
capital gain/(loss) and reinvestment income. This measure gives the
actual return of investments unlike the conventional measure of average
yield on investments. The total return concept recognises the impact of
market interest rate movements on portfolio values.
 Important Financial Ratios of Banks
22 . Efficiency (Other Income) Ratio = Non Interest Income
Total Income or ( Total Expenses)

• Higher the ratios, the Bank is more into other activities other
than lending.
 Important Financial Ratios of Banks
• Non-interest expenses ratio (Non-Interest Expenses to Total Income),

Non Interest Expenses

Total Income
 Important Financial Ratios of Banks
26. Business or Net Profit per Employee

The ratios indicate the staff productivity in banks, which is very important in a
competitive environment. A comparison of the ratios among the Peer Group
would reveal efficiency and staff productivity of banks

Profit/Employee …..

Business
Number of employees
Asset Liability Management
 Interest Rate Risk (IRR)
Management in Banking Book
Interest Rate Risk (IRR)
Management
 Rate Sensitive Assets
• Rate Sensitive Assets: These are those assets that are
sensitive to changes in interest rate movements.
• Non Sensitive Assets
• Cash/ Balances with Central Bank
• Fixed Assets
• Other Assets
• Sensitive Assets:
• Loans
• Investments
• Balances with other banks
• Call Money
 Rate sensitivity ….Based upon….. Re
pricing time bucket
• Time Buckets……….8 Time Buckets …based upon Re pricing…Re
pricing Buckets
•
1. 1 to 28 days
2. 29 days and up to 3 months
3. Over 3 months and up to 6 months
4. Over 6 months and up to 1 year
5. Over 1 year and up to 3 years
6. Over 3 years and up to 5 years
7. Over 5 years
8. Non -Sensitive

• Re Pricing of Asset or Liabilities in different time bucket

• Interest Rate Sensitivity…………of Asset
• Interest Rate Sensitivity ……… of Liability
 Liability
Rate sensitivity and Re pricing time bucket
• Capital, Reserves and Surplus
Non-sensitive

• Demand Deposits (CASA)

Current Account…….Non-sensitive.

SB ……RSL
 Liability
Rate sensitivity and Re pricing time bucket
• Term Deposits & CD….fixed rate of Interest
• Sensitive….is re priced on maturity. The amounts
should be distributed to different buckets on the basis
of remaining term to maturity.

• Term Deposits….floating rate of Interest

• the amounts may be shown under the time bucket
when it is due for re pricing.
 Liability
Rate sensitivity and Re pricing time bucket
• Borrowings…. Includes…..Refinances, Inter Bank Borrowing, Call Money Borrowing, Zero
Coupon
– Borrowings ………Fixed Rate

• Sensitive and re prices on maturity. The amounts should be distributed to different

buckets on the basis of remaining maturity.

– Borrowings….Floating Rate
• Sensitive and re prices when interest rate is reset…….. distributed to the appropriate
bucket which refers to the re pricing date.
– Borrowings – Zero Coupon
• Sensitive and re prices on maturity. The amounts should be distributed to the
respective maturity buckets.

• Provisions other than for loan loss and depreciation in investments

– Non-sensitive
• Repo….. Sensitive……first Time Bucket…at the maturity
 Asset
Rate sensitivity and Re pricing time bucket

• Cash…Non - sensitive.
• Balances with RBI
………….Non - sensitive
• Balances with other Banks
– Current Account………Non - sensitive
– Call Money………….sensitive……. 1-14 days bucket
 Asset
Rate sensitivity and Re pricing time bucket
• Investments…… Fixed Rate / Zero Coupon
• Sensitive on maturity
 Investments…… Floating Rate
 Sensitive at the next re pricing date
• Shares/ Mutual Funds…… Non Sensitive
• Cash Credits / Overdrafts/ Loans repayable on demand and Term Loans
Sensitive only when Base Rate is changed…….Re pricing Date.
If there is anticipation of frequent changes in Base rate, then
time bucket for rate sensitive positions will coincide with
future change in Base Rate/MCLR
For Loan with fixed Rate of Interest…the rate sensitive position
will be reflected at maturity.
 Asset
Rate sensitivity and Re pricing time bucket
• Net NPA
Sub-standard Asset(SA)……. Over 3-5 years
bucket…..sensitive during the Recovery period
Doubtful and Loss……… Over 5 years bucket…… sensitive
during Recovery the period
• Fixed Assets…..Non Sensitive
• Reverse Repo……sensitive in 1-14 days bucket
 Sample Interest Rate Statement(IRS)
Rs. in Crores
1 – 3 months 3 – 6 months 6 – 12 months

RSA 200 300 200

RSL 100 500 300
RS Net Gap 100(AS) -200(LS) -100(LS)

RS Cumulative Gap 100 -100(LS) -200(LS)

Observations:
•One year cumulative gap is ‘liability sensitive’.
•The increase in interest rate would result in reduction of NII.
•For 1% rise in interest rate, NII will decline by Rs.2 crore.
 A TYPICAL INTEREST RATE SENSITIVITY ANALYSIS….interpret
(Rs. in Crores)
RESIDUAL MATURITY TOTAL TOTAL ASSETS GAP
LIABILITIES (B) (C=B-A)
(A)

1 TO 28 DAYS 2188 2481 293

29 DAYS TO 3 MONTHS 565 978 413
OVER 3 MON. TO 6 MONTHS 1557 4256 2699
OVER 6 MON. TO 1 YEAR 1544 789 -755
OVER 1 YEAR TO 3 YEARS 2995 2980 -15
OVER 3 YEARS TO 5 YEARS 11023 7895 -3128
OVER 5 YEARS 4349 3361 -988
NON SENSITIVE 5870 7680 1810
TOTAL 30091 30420 329
 Types of Interest rate risks
• Rate Sensitive Gap Risk
• Basis Risk
• Yield Curve Risk
Gap risk- example
(In a particular Bucket)
 Gap Analysis

– Take a view on change in ROI for different RSA &

RSL
– Multiply the value of RSA & RSL in a time bucket
by expected interest rate change
– Compute gap
 Gap risk
• Rate Sensitive Asset & Liability Position are
different in a particular Re pricing time bucket

– Lead to gap risk

 Gap report
• RSA> RSL= POSITIVE Rate sensitive GAP
• RSL> RSA= NEGATIVE Rate sensitive GAP
• RSA=RSL= NEUTRAL GAP
• Compute
– individual gaps for different time buckets and
– cumulative gaps
 Gap Analysis…
Challenge
• Identify Rate Sensitive Position and re pricing
date
Limitation

• Ignores basis risk

• Assumes Parallel Shift in Yield Curve
• Ignores time value of money
Gap Risk
Basis Risk
 Basis risk
• Change in Interest rate on assets and liabilities is not in the
same proportion in a particular time bucket

• If Repo is Rs. 50 crore & deposits is Rs.75 crore, whereas loans

= Rs 125 cr
• When Repo Rate declines by 50 bps, deposit rates is declined
by…… 1.5%. and Lending Rate by….. 1.0%

• Delta NII & NIM ?

• Therefore, basis risk arises when interest rates of different
assets and liabilities change in different magnitudes
 Basis Risk – Example….Rise in ROI
• Interest rates on assets and liabilities do not change in
same proportion…..in 1 year Time Bucket
---------------------------------------------------------------------
RS Liability……Interest Expenses
RSL
• Call ( 50 ) goes up by 2% = (1) Total 200
• Variable Repo ( 50 ) goes up by 1.5% = (0.75)
• Deposit ( 100 ) rate goes up by 2% = (2.0)
---------------------------------------------------------------------
RS Asset……Interest Income
RSA
• 364 - TBill (30) yield goes up by 2% = 0.6 Total 150
• Base rate for advances (120) goes up by 2.5% =3
----------------------------------------------------------------------
• (NII) = ( 0.6+3 ) - (1 + 0.75 + 2.0) = -0.15
 No Gap Risk
But Basis Risk
 Basis Risk Computation( 1 Year Time)
(Rs in crore)
Rate Sensitive Liabilities Rate Sensitive Assets

Saving Bank 30 T Bills 20

Term Deposits 70 Advances 80

--------------- ---------------
Toatl Liabilities 100 Total Assets 100
--------------- ---------------

Gap = RSA - RSL = 0

Interest Rate falls by the following %
Savings Bank a/c -0.30% -0.09 91 day T Bills -0.60% -0.12
Term deposits -0.50% -0.35 Advances -1.00% -0.80
--------------- ---------------

Fall in interest Fall in interest

expenses -0.44 income -0.92
--------------- ---------------
 Basis risk…
• What happens to NII?

• Fall in NII by Rs 0.48 crore.

• Change in NII is -0.48 crore……
 Yield curve Risk

• If the floating rates are based on different

benchmarks for assets and liabilities
• A 2 year loan is funded through a 91 day deposit

• Deposit is taken at 100 basis points above 91 day T-

bill @ 6 %.... (= 100 cr)……6% + 1% = 7%

• Loan is priced 100 basis points above 364 T-bill…@

6.75 %.... 6.75% +1% ( 100 cr)…..7.75%

• Spread is 7.75% - 7% = 75 basis points

 Yield Curve Risk
Date 91 T Bill Mark Up 364 T Bill Deposit Rate Loan Rate
Jan-18 6% 1% 6.75% 7.00% 7.75%
Jan-19 5.50% 1% 6.00% 6.50% 7.00%
Diff -0.50% -0.75% -0.50% -0.75%
Spread -0.75%

delta IE 100*(6.5% - 7% ) -0.5

delta II 100*(7% - 7.75%) -0.75
delta NII -0.25
delta NIM -0.25%
• Gap Risk + Basis Risk + Yield Curve Risk
Hedging of ALM Interest Risk ?
Through both BS & off-BS Items
 ALM Risk Mgt Strategies for Hedging
Banking Book ……..BS Strategy

Situation: - ve Gap, Interest View: Increasing ROI

– Decrease RSL or Increase RSA/both

Situation: - ve Gap, Interest View: declining ROI

– Do nothing…

71
Situation: + ve Gap, Interest View: Decreasing ROI
– Increase RSL or Decrease RSA/both

Situation: + ve Gap, Interest View: Rising ROI

– Do nothing
 RBI Stance on Lending rates (1960-2016)
Repo
October, Minimum Interest rate on Advances Rate
1960 in
Maximum Lending rate 2004
March,
1968

January, Minimum Lending rate

1970

March, Maximum Lending rate

1976

October, Free Lending rate above Rs 2 Lakhs

1994

2003 BPLR - for bringing transparency in lending rates (Banks can not lend
below BPLR)

July, 2010 Base rate

April,2016 MCLR
 Lending Rate

• BPLR(1st April 2003)---- Base Rate(1st July 2010)-----

MCLR(1st April 2016)
BASE RATE…W..E.F JULY,2010
BPLR was introduced in 2003 as a move
towards interest rate deregulation in the
Banking sector

Some Facts
• Sub PLR Lending (PSU) constitutes 67% of Total
Lending as March 2009.
• Sub PLR Lending (Foreign banks) constitutes 81%
of Total Lending as March 2009.
• Sub PLR Lending (Pvt. Sec) constitutes 84% of
Total Lending as March 2009.
 PLR…..Extract from Live Mint in 2010
• RBI observed that there is under pricing of credit for corporates, while
there could be overpricing of lending to SMEs

• Competition among banks has turned the pricing of a

significant proportion of loans far out of alignment with the
BPLR and in a non-transparent manner,” RBI said in its report
on currency and finance.

• The report adds that the BPLR has ceased to be a reference

rate(Benchmark Rate) and transmission mechanism has not
been effective.
 RIP….BPLR

• There is a structural problem .

• So banks preferred to keep their BPLR at an
artificially high level and charge most of their
borrowers a rate much below the benchmark
rate.

• In particular, the fixation of BPLR continues to be

more arbitrary than rule-based.

• Therefore, the concept of arriving at the BPLR needs to

be looked into with a view to making it more
transparent
 RIP….BPLR
• Despite that, most of the banks ended up having
their BPLRs in the same range even though their
cost of funds, overheads and level of non-performing
assets were not alike.

• Typically, State Bank of India, the largest lender, takes

the lead in setting the rate and others follow.
 Why Base Rate….
• The BPLR system, introduced in 2003, fell short of its original objective of
bringing transparency to lending rates…. mainly because under the BPLR
system, banks could lend below BPLR.

• For the same reason, it was also difficult to assess the transmission of
policy rates of the Reserve Bank to lending rates of banks.

• Hence, the Base Rate system is aimed at enhancing transparency in

lending rates of banks and efficiency in transmission of monetary policy

• The Base Rate system will replace the BPLR system with effect from July 1,
2010.
 Why Base Rate….
• Issues In Transparency
– No Hidden additional costs

– Everything should be clear to the Borrower at the

Beginning

Effectiveness in Transmission Mechanism

• Downward Stickiness of BPLR

– Major Victims are borrower in housing loan.

 Components of Base Rate
• 1.Cost of Deposits
– CA….SB….TD…
• 2.Negative Carry on CRR and SLR
– Negative carry on CRR and SLR balances arises because the return on CRR
balances is nil, while the return on SLR balances (proxied using the 364-day
Treasury Bill rate) is lower than the cost of deposits .
– Negative carry cost on SLR and CRR was
arrived at by taking the difference between RACOF and the Cost of Deposits
– ROI on CRR is 0% and ROI on SLR is 364 T bill
• 3. Overhead Cost
– Employee Cost wrt. Deployable Deposits
– Total deposits less share of deposits locked as CRR and SLR balances (1-6%-24%)…70%
of Total Outstanding Deposits
 Components of Base Rate
• 4. Return on Deployable Deposits

• (Net Profit//Deployable Deposits)

Base rate = 1+2+3+4

Loan pricing = Base rate + Product Specific Operating cost(139)

+ Default Premium + Maturity Premium Yield Curve

Rating of the Obligor

 Why Base Rate was removed?
• The central bank has cut its key lending rate by 125 basis points
(bps) so far but banks haven’t passed on beyond 60-70 basis points.
• It could not solve the problem of lack of monetary transmission in
the banking system.
• Base rates still didn’t reflect the intended signals from the RBI on
interest rates, since banks still found a way to manipulate the final
lending rate.
• It was still downward sticky
• The main reason for this was banks were using their average cost of
funds. The cost of funds raised in the past may be very high.
• This created distortions since the longer maturity deposits did not
easily reflect the changes at the short end and hence banks were
unable to pass on RBI rate cuts to the borrower using the average
cost system
 RBI Report on Loan Rates
• Submitted in January 2014.

• Migration to MCLR for better pricing, monetary

policy transmission and ALM.

• A uniform Indian Banks Base Rate (IBBR) may be

introduced, to avoid ambiguity across banks.
 MCLR
• The marginal cost of funds based lending rate (MCLR) refers to
the minimum interest rate of a bank below which it cannot
lend, except in some cases allowed by the RBI.

• It is an internal benchmark or reference rate for the bank.

• MCLR actually describes the method by which the minimum

interest rate for loans is determined by a bank - on the basis
of marginal cost or the additional or incremental cost of
arranging one more rupee to the prospective borrower.
 Reasons for introducing MCLR
• RBI decided to shift from base rate to MCLR because the rates
based on marginal cost of funds are more sensitive to changes in
the policy rates.

• This is very essential for the effective implementation of monetary

policy. Prior to MCLR system, different banks were following
different methodology for calculation of base rate /minimum rate –
that is either on the basis of average cost of funds.
• Thus, MCLR aims to improve the transmission of policy rates into
the lending rates of banks.
• To bring transparency in the methodology followed by banks for
determining interest rates on advances.
• To ensure availability of bank credit at interest rates which are fair
to borrowers as well as banks.
• To enable banks to become more competitive and enhance their
long run value and contribution to economic growth.
 MCLR Comparison
• https://www.bankbazaar.com/home-
loan/mclr.html
• The MCLR methodology for fixing interest rates
for advances was introduced by the Reserve Bank
of India with effect from April 1, 2016.
• This new methodology replaces the base rate
system introduced in July 2010.
• In other words, all rupee loans sanctioned and
credit limits renewed w.e.f. April 1, 2016 would
be priced with reference to the Marginal Cost of
Funds based Lending Rate (MCLR) which will be
the internal benchmark (means a reference rate
determined internally by the bank) for such
purposes.
Calculation of MC of Funds
 Balance outstanding in the
Rates offered on the date books of the bank on the
Marginal cost
Sl Source of funds (excluding equity) of review/rates at which date of review as a
(1) x(2)
funds raised percentage of total funds
(excluding equity)

(1) (2)
1 Deposits
a Current Deposits 0.00 7% 0.00
b Savings Deposits 4.00 21% 0.84
c Term deposits *
Upto one month 4.5 2% 0.09

One month to six months 7.00 10% 0.70

Six months to one year 7.5 26% 1.95

More than one year 8.0 22% 1.76

2 Borrowings
RBI 7.25 2% 0.15

Other banks and institutions 7.20 2% 0.14

Bonds and debentures 9.0 8% 0.72

Marginal cost of funds 6.35

• Cost of deposits should be calculated using
the latest interest rate/card rate payable on
current and savings deposits and the term
deposits of various maturities.

• Cost of borrowings should be arrived at using

the latest rates at which funds were raised.
 (II) Average Return on Networth

• Average return on net worth is the hurdle rate of

return on equity determined by the Board or
management of the bank.

• It is expected that the component representing

‘return on networth’ will remain fairly constant
and any change would be made only in case of a
major shift in the business strategy of the bank.
• Marginal cost of funds which is a concept under the
MCLR methodology comprises of Marginal cost of
borrowings and return on networth, appropriately
weighed.

• Marginal cost of funds = (92% x Marginal cost of

Deposits & borrowings) + (8% x Return on Networth)

• Thus, marginal cost of borrowings has a weightage of

92% while return on net worth has 8% weightage in the
marginal cost of funds.
• Here, the weight given to return on networth is set
equivalent to the 8% of risk weighted assets prescribed
as Tier I capital for the bank.
 III. Negative carry on CRR
• Negative carry on the mandatory CRR arises
because the return on CRR balances is nil..
• Negative carry on the mandatory levels of CRR
should be calculated using the following
formula:

• Negative Carry = (CRR%*MC of Funds)/(1-CRR)

 (IV) Overhead cost

• Associated with providing the loan product,

includes cost of raising funds.

• Banks may calculate all overhead costs as a

percentage of marginal cost of funds for
computing MCLR.
 (V)Tenor Premium

• The change in tenor premium cannot be

borrower specific or loan class specific. In
other words, the tenor premium will be
uniform for all types of loans for a given
residual tenor.
 MCLR
• I + II+III+IV+V = MCLR
 (v) Premium
• Depends on Credit Risk of Obligor

• PD*LGD
(VI)Customer Relationship Discount
 Interest Rates on Loans

• The actual lending rates on the loans will be

determined by adding the components

• MCLR + V + VI = Loan Rate

Estimating the Cost of Equity
Capital
 Approaches
• Book Value Approach
• Market Value Approach
 Book Value Approach
• The measure of Return on Equity for the bank
• Calculated as PAT/(Average Capital and Reserves)
• The bank management can base its estimate of future cost of
capital on this historical ratio
• However, the ratio has its drawbacks
– Does not benchmark the returns of the bank on any market
performance
– Does not take into consideration the risk perceptions of equity
investors
– Is based on very short term historical (one year) performance
 Market Value Approach

• Using the Capital Asset Pricing Model (CAPM) Approach, the cost of equity
capital (hurdle rate) for any firm is given by the formula:
E(rb) = [rf + β* {E(rm) - rf}]

“Shareholders will require a return from the bank shares in excess of the
risk-free rate to compensate them for undiversifiable risk”

E(rb) = The Cost of Equity Capital/ Hurdle Rate

rf = The expected return on a default risk free asset
β = Beta coefficient of bank stocks is calculated by time series
regression of the bank’s stock returns and the market index
returns
E(rm) = The expected return on a market equity index We can
choose any broad based market index like S & P CNX Nifty or
SENSEX and calculate the long run average (long run is usually 5 to
10 years) annualized return on the index
 Market Value Approach

• Relevance of β
• Arises from the regression equation
Signifies the change in the returns for the bank stock for a 1% change in
the market returns
– β >1: bank stock riskier than market; if the market return falls by 1%,
the bank stock is expected to fall by more than 1%
– β <1: bank stock less risky than the market
• Long term investors in the stock of a bank expect to earn a
risk premium in proportion to the β to compensate them for
the higher (or lower) risk of the bank compared to the market
 Market Value Approach

• Stock Market Premium

{E(rm) - rf}
• Bank stock Premium
β* {E(rm) - rf}]
 Duration

• Duration is a measurement of how long, in

years, it takes initial cash outflow to be repaid
by its internal cash flows.
 DURATION
Inflows 8 8 8 8 108

DURATION
Discounted 7.34 6.73 6.18 5.67 76.51
value
 N

 CF t X DFt X t
D t 1
N

 CF
t 1
t X DFt
 N

wt i i

D  i 1

CFt X DFt
wt  N

 CF
t 1
t X DFt
 Modified Duration

• P1 - P0 = - MD* P0 r
• MD = D/ (1+YTM)
• DP =

• Modified Duration * (Dr)…..MDuration Effect

• P1 - P0 = - MD* P0 r
 (P+P) – P > P – (P-P)

P+P”
P
Price
P-P

r-r r r+r

Interest Rate
 Total Change
• DP =

• Modified Duration * (Dr)…..MDuration Effect

• 0.50 * (Dr)2 * Convexity ……..Convexity Effect

• P1 - P0 = - MD* P0 r +C*0.5* P0(r)2

 Modified Duration Gap…
MDURgap = MDURa – MDURL, Where

MDURgap = Modified Duration of the gap

MDURa = Modified Duration of the Assets
MDURL = Modified Duration of the Liabilities

• MDUR Gap is also known as Modified Duration of Equity

Change in Market Value Equity
 MVE = - MDUR gap x i x MVE
 Change in Market Value of Equity

• The steps involved are:

1. Calculate the market value of all rate sensitive assets and liabilities by
using appropriate discount.

2. The Modified duration of all Assets and Liabilities is calculated.

3. MDURgap will be calculated…… from step 2

4. The change in Market Value of Equity is calculated using the following

equation:
 MVE = - MDURgap x i x MVE
Market Value of Equity(MVE) Amount (Rs. Crore)
MCaP 1875.00
Modified Duration of Gap
MDA (Weighted Modified Duration of Assets) 2.69
MDL (Weighted Modified Duration of Liabilities) 0.78
MDGAP = DA – DL 1.92
For a 1% increase in Rate,the drop in MVE -53.94
For a 1% drop in Rate,the rise in MVE 53.94
 Market Value of Equity
• The MDURgap represents the sensitivity of the MVE to change
in interest rates.

• By multiplying the MDUR Gap with the expected in change in

interest rates, we can assess the interest rate risk.

• If the MDUR Gap of the balance sheet is 1.6 and the MVE is
Rs.500 crores then with a 100 basis points increase in interest
rates, the decline in MVE will be Rs. 8 cr or…..drop by 1.6%.
 Modified Duration Gap Analysis
• Compute modified duration of individual items of
assets and liabilities

• Modified Duration of a portfolio of similar items

of assets and liabilities is the weighted duration of
all assets and liabilities in that portfolio

• Modified Duration of all items of assets and

liabilities in the balance sheet is the weighted
Modified duration of all assets and liabilities
 Methodology for computation of MVE

• If the MDuration Gap is positive,

• a decrease in rate of interest rates will increase the
MVE
• an increase in rate Market interest rates will decrease
the MVE

• When MDuration gap is negative,

• MVE increases when interest rate increases

• MVE decreases when interest rates decline.
Modified Duration Gap Analysis
(Contd..)

Interest Rate
Sign MD Gap Movement Change in MVE
- + - +
- + + -
- - - -
- - + +