November 30, 2012

MA0036 [Financial Systems and Commercial Banking] Set2 Q4

Q4. How is asset liability management done in banks?

Ans:

Asset Liability Management (ALM) is a comprehensive and dynamic framework for measuring, monitoring and managing the market risk of a bank. It is the management of structure of balance sheet (liabilities and assets) in such a way that the net earning from interest is maximized within the overall risk-preference (present and future) of the institutions.  The ALM functions extend to liquidly risk management, management of market risk, trading risk management, funding and capital planning and profit planning and growth projection. 

Benefits of ALM - It is a tool that enables bank managements to take business decisions in a more informed framework with an eye on the risks that bank is exposed to. It is an integrated approach to financial management, requiring simultaneous decisions about the types of amounts of financial assets and liabilities - both mix and volume - with the complexities of the financial markets in which the institution operates.

The concept of ALM is of recent origin in India.  It has been introduced in Indian Banking industry w.e.f. 1st April, 1999.  ALM is concerned with risk management and provides a comprehensive and dynamic framework for measuring, monitoring and managing liquidity, interest rate, foreign exchange and equity and commodity price risks of a bank that needs to be closely integrated with the banks’ business strategy.

Therefore, ALM is considered as an important tool for monitoring, measuring  and managing the market risk of a bank.   With the deregulation of interest regime in India, the Banking industry has been exposed to the market risks.   To manage such risks, ALM is used so that the management is able to assess the risks and cover some of these by taking appropriate decisions.

The assets and liabilities of the bank’s balance sheet are nothing but future cash inflows or outflows. With a view to measure the liquidity and interest rate risk, banks use of maturity ladder and then calculate cumulative surplus or deficit of funds in different time slots on the basis of statutory reserve cycle, which are termed as time buckets.  

As a measure of liquidity management, banks are required to monitor their cumulative mismatches across all time buckets in their Statement of Structural Liquidity by establishing internal prudential limits with the approval of the Board / Management Committee.

The ALM process rests on three pillars:
i. ALM Information Systems
o Management Information Systems
o Information availability, accuracy, adequacy and expediency

ii. ALM Organization
o Structure and responsibilities
o Level of top management involvement

iii. ALM Process
o Risk parameters
o Risk identification
o Risk measurement
o Risk management
o Risk policies and tolerance levels.

As per RBI guidelines, commercial banks are  to distribute the outflows/inflows in different residual maturity period known as time buckets.  The Assets and Liabilities were earlier  divided  into 8 maturity buckets (1-14 days; 15-28 days; 29-90 days; 91-180 days; 181-365 days, 1-3 years and 3-5 years and above 5 years), based on the remaining period to their maturity (also called residual maturity).  All the liability figures are outflows while the asset figures are inflows.   In September, 2007, having regard to the international practices, the level of sophistication of banks in India, the need for a sharper assessment of the efficacy of liquidity management and with a view to providing a stimulus for development of the term-money market, RBI revised these guidelines and it was provided that

 (a) The banks may adopt a more granular approach to measurement of liquidity risk by splitting the first time bucket (1-14 days at present) in the Statement of Structural Liquidity into three time buckets viz., next day , 2-7 days and 8-14 days.   Thus, now we have 10 time buckets.

After such an exercise, each bucket of assets is matched with the corresponding bucket of the liability.   When in a particular maturity bucket, the amount of maturing liabilities or assets does not match, such position is called a mismatch position, which creates liquidity surplus or liquidity crunch position and depending upon the interest rate movement, such situation may turnout to be risky for the bank.    Banks are required to monitor such mismatches and take appropriate steps so that bank is not exposed to risks due to the interest rate movements during that period.

 (b) The net cumulative negative mismatches during the Next day, 2-7 days, 8-14 days and 15-28 days buckets should not exceed 5 % ,10%, 15 % and 20 % of the cumulative cash outflows in the respective time buckets in order to recognise the cumulative impact on liquidity.

The Board’s of the Banks have been entrusted with the overall responsibility for the management of risks and is required to decide the risk management policy and set limits for liquidity, interest rate, foreign exchange and equity price risks.

Asset-Liability Committee (ALCO) is the top most committee to oversee the implementation of ALM system and it is to be headed by CMD or ED.  ALCO considers product pricing for deposits and advances, the desired maturity profile of the incremental assets and liabilities in addition to monitoring the risk levels of the bank. It will have to articulate current interest rates view of the bank and base its decisions for future business strategy on this view.

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