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PROJECT REPORT
ON “ASSET LIABILITY MANAGEMENT IN INDIAN BANKING SECTOR”
Submitted by: XYZ
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ARMY INSTITUTE OF MANAGEMENT & TECHNOLOGY
Certificate of originality
I_____________________ Roll no________________________________ class of 1234, a full time bonafide student of second year of master of business administration (MBA) programe of Army Institute of Management and Technology. I hereby Certify that this project work is carried out by me at_____________________and The report submitted in partial fulfillment of the programe is an original work of mine under the guidance of industry mentor_______ and faculty mentor________________ Is not biased and or reproduced from any existing work of any other person or earlier work undertaken at any other time for any other purpose ,and has not been submitted anywhere else at any time.
(Student signature) Date: (Faculty mentor’s signature) Date:
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ACKNOWLEDGEMENT
It gives me great pleasure in acknowledging the invaluable assistance extended to me by various personalities in the successful completion of this report. My debts are due to many individuals who provided me guidance, advice and useful comments that helped in the revising of the report. As usual, the debts can be only warmly acknowledged but never fully recompensed My thanks are due to Mr. XYZ, .Faculty Member, Management Studies, AIMT, Greater Noida, who provided me the knowledge about the field and the timely guidance which helped me a lot on the way for the completion of this report.
(XYZ)
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Table of contents
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Introduction…………………………………………….. 5
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Objectives and Scope of Study…………………………7
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Literature review ………………………………………8
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Research Methodology…………………………………19
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Importance of study……………………………………56
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Result and Analysis…………………………………….57
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Conclusion of the study………………………………..58
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Bibliography……………………………………………62
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Appendix……………………………………………….
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1. INTRODUCTION Introduction: Banking is the business of accepting deposits and lending money. Banking defined in this way, however, is carried out by some other financial intermediaries that perform the functions of safeguarding deposits and making loans. Building Societies and Finance houses, for example, are not normally referred as banks and are not regarded as being part of the banking system in narrow, traditional sense. The key to this confusing distinction between banking and banking system is that the latter is the principal mechanism through which the money supply of the country is created and controlled. The banking system is still normally understood to include the Commercial banks, the Secondary banks, the Central bank, the Merchant bank or accepting houses and the Discounts houses, but to exclude the Saving banks and Investment banks and other intermediaries. The deposits of some types of bank, e.g. the post office savings bank, cannot be used in the settlement of debt until they are withdrawn, but a deposit in a commercial bank can be used to settle debts by the use of cheques of credit transfer. When the manager of the branch of one of the clearing banks opens an overdraft account for a customer, the loan creates a deposit, that is to say, a book debt has been incurred to a customer in return for the promise to repay it. Whether or not the overdraft is secured by Collateral Security, such as an Insurance policy, or some other asset, when the customer draws upon the loan, the bank has added to the total money supply. In Balance sheet terms, the deposit is claim on the bank – that is, a Liability – while the customer’s promise to repay it (or the collateral security) is an asset to bank. In the absence of govt. control on lending, the limitation on bank’s ability to create deposit is their obligation, if they are to remain in business, to pay out Current Account deposits in cash on demand. Since the bank’s customers meet most of their for money by writing cheques on their deposits, the cash holdings the bank need are only small fraction of their total deposits. This ratio between their deposit liabilities and their cash holding is called cash ratio.
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Banks also hold other liquid assets. The bank always tries to keep its reserves as possible to the minimum, since no return at all is earned on holding of cash and a relatively low return in money market. The banking system is based on confidence in system’s ability to meet its obligations. In the short run, no bank is able to meet all its obligation in cash, and if demands upon it exhausted its cash reserves, the bank would be obliged to close its doors.
Banks are in the business of maturity transformation. They accept deposits of varying maturity from customers and pay loans of different maturities on the other side. Apart from maturity transformation, banks also transfer the risk appetite of customers. They accept fixed rate deposits and give floating rate loans.Similarly they accept floating rate deposits and pay fixed rate loans. All these activities result in concentration of liquidity and interest rate risk in a bank’s book. Bankers have been managing these risks since the evolution of banking. It is only in the recent past that the complexities of liquidity and interest rate risk management have increased. Several factors have lead to this complexity; prominent ones being increased sophistication of banking products and volatile financial markets. The primary objective of an Asset Liability Management system is liquidity risk management and interest rate risk management.
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2. OBJECTIVES AND SCOPE OF STUDY Objectives of Study: The objectives of the study are: To provide an in depth knowledge of the concept of Asset Liability Management (ALM)
Analyze the various methodologies undertaken in the Indian Banking Sector (including public and private sectors) for ALM
Analyze the strategies to be followed from both asset and liability side
Elucidating upon the importance of ALM
Providing a glimpse of the future of ALM in the Indian Banking sector
Scope of study: The scope of study is limited to secondary data provided by the past-maintained records of various banks. Further, the study is also based on the data extracted from the journals, books, and magazines. Also the data has been squeezed from the Internet.
3. LITERATURE REVIEW
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Banking Basics: A good way to understand how banks work is to imagine starting your own bank. The first thing you need to do is put up some of your own money. You won’t receive a banking license unless you have your own capital at risk. Banking is all about trust. We trust that the bank will have our money for us when we go to get it. We trust that it will honor the checks we write to pay our bills. The thing that's hard to grasp is the fact that while people are putting money into the bank every day, the bank is lending that same money and more to other people every day. Banks consistently extend more credit than they have cash. That's a little scary; but if you go to the bank and demand your money, you'll get it. However, if everyone goes to the bank at the same time and demands their money (a run on the bank), there might be problem. Banks keep a certain percentage of their money in reserve, if everyone came to withdraw their money at the same time, there wouldn't be enough. The key to the success of banking, however, still lies in the confidence that consumers have in the bank's ability to grow and protect their money. Because banks rely so heavily on consumer trust, and trust depends on the perception of integrity, the banking industry is highly regulated by the government.
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Managing Loans and Other Investments
As your business develops, some customers will deposit their own money to open checking accounts. Others will invest in your savings accounts and certificates of deposit (term loans) which must pay a competitive interest rate. Still others will seek loans from the bank. It is up to you to determine whether prospective borrowers are good credit
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risks, and will be able to pay the interest charges and return the principal on the specified date. •
Accounting Needs:
In managing your bank, you will need an accounting system to determine how your decisions are likely to affect the bank’s profitability. The most important account is the balance sheet. This shows at any given moment, the bank’s assets (what it owns), its liabilities (what it owes to others), and its net worth (what belongs to the owners). Net worth, or equity, is equal to assets minus liabilities. Your equity should remain positive and preferably growing. If it ever gets too low relative to total assets, your regulator may close the bank. •
Balance Sheet and Earnings Forecasts
If your bank does well, the balance sheet will expand with new assets and liabilities. The equity should also increase, assuming you retain some of the profits in the bank rather than pay them all out as dividends to the owners. The earnings forecast are based on expected earning rates of the bank’s assets and the cost of borrowed funds. Also shown is the expected cost of operations or fixed costs, covering rent, insurance, utilities, salaries, etc. The entries in blue are items that you might try to modify to see how they would affect the key performance measure, the return on equity. Of course, you must maintain the required minimum ratios set by the regulators.
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Growth Management
You have acquired a substantial amount in deposits, some of which are ordinary checking accounts that pay no interest. Others were borrowed at market rates. All deposits whether or not they bear interest have associated costs. With the additional funds available from deposits, you have redistributed your assets to what you hope will enhance future earnings in reserves, T-bills, loans to other banks, and ordinary loans. •
Required Operating Ratios
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The capital ratio is the ratio of a bank’s equity to a risk-weighted sum of the bank's assets. The weightings are 0 for reserves, 0 for government securities, 0.2 for loans to banks, and 1.0 for ordinary loans. A minimum capital ratio of 8% is required. The leverage ratio is the ratio of a bank's equity to the unweighted sum of its total assets. The required minimum is 3%. The reserve ratio is the ratio of a bank's reserves (deposits at the RBI plus vault cash) to its demand deposits, i.e. checking deposits. The required minimum is 10% for large banks, but only 3%, which is the case for your small bank. •
How Transactions Affect Operating Ratios
When a bank issues an ordinary loan, its assets (A) and liabilities (L) increase equally. Its reserves (R) remain unchanged, which results in a decrease in its reserve ratio (R/L). Its equity, i.e. capital (C = A-L) remains unchanged, which results in a decrease in its capital ratio (C/A). When the borrower spends the funds, assuming they end up in a different bank, R, A, and L decrease equally. Since R is normally a small fraction of L, the reserve ratio decreases by an amount roughly equal to the fractional change in R. Since C is normally a small fraction of A, the capital ratio increases by an amount roughly equal to the fractional change in A. When the borrower pays interest on the loan out of a deposit within the bank, L decreases while A and R remains unchanged. This results in an increase in both the reserve ratio and the capital ratio. If the borrower pays interest from an outside source, A and R increase while L remains unchanged. This results in an increase in both the reserve ratio and the capital ratio. When the borrower repays the loan from a deposit within the bank, R remains unchanged while A and L decrease equally. This results in an increase in both the reserve ratio and the capital ratio. If the borrower repays the loan from an outside source, R increases while A and L remain unchanged. This results in an increase in reserve ratio but no change in the capital ratio. When a bank buys something for itself, it may issue a bank draft in payment. If the recipient deposits the draft in the same bank, he receives a deposit which increases L, while A and R remains unchanged. If he deposits it in another bank, A and R decreases
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while L remains unchanged. In both cases, the capital ratio and reserve ratio of the issuing bank decrease.
Types of Banks: There are several types of banking institutions, and initially they were quite distinct. Commercial banks were originally set up to provide services for businesses. Now, most commercial banks offer accounts to everyone. Savings banks, savings and loans, cooperative banks and credit unions are actually classified as thrift institutions. Each originally concentrated on meeting specific needs of people who were not covered by commercial banks. Savings banks were originally founded in order to provide a place for lower-income workers to save their money. Savings and loan associations and cooperative banks were established to make it possible for factory workers and other lower-income workers to buy homes. Credit unions were usually started by people who shared a common bond, like working at the same company (usually a factory) or living in the same community. The credit union's main function was to provide emergency loans for people who couldn't get loans from traditional lenders. These loans might be for things like medical costs or home repairs. Now, even though there is still a differentiation between banks and thrifts, they offer many of the same services. Commercial banks can offer car loans, thrift institutions can make commercial loans, and credit unions offer mortgages!
History Of Banking In India: Banking in India originated in the first decade of 18th century with The General Bank of India coming into existence in 1786. This was followed by Bank of Hindustan. Both these banks are now defunct. The oldest bank in existence in India is the State Bank of India being established as "The Bank of Bengal" in Calcutta in June 1806. A couple of decades later, foreign banks like Credit Lyonnais started their Calcutta operations in the 1850s. At that point of time, Calcutta was the most active trading port, mainly due to the trade of the British Empire, and due to which banking activity took roots there and
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prospered. The first fully Indian owned bank was the Allahabad Bank, which was established in 1865. By the 1900s, the market expanded with the establishment of banks such as Punjab National Bank, in 1895 in Lahore and Bank of India, in 1906, in Mumbai - both of which were founded under private ownership. The Reserve Bank of India formally took on the responsibility of regulating the Indian banking sector from 1935. After India's independence in 1947, the Reserve Bank was nationalized and given broader powers.
The Bank of Bengal, which later became the State Bank of India.
Nationalization: The nationalization of banks in India took place in 1969 by Mrs. Indira Gandhi the then prime minister. It nationalized 14 banks then. These banks were mostly owned by businessmen and even managed by them. Before the steps of nationalization of Indian banks, only State Bank of India (SBI) was nationalized. It took place in July 1955 under the SBI Act of 1955. Nationalisation of Seven State Banks of India (formed subsidiary) took place on 19th July, 1960. The State Bank of India is India's largest commercial bank and is ranked one of the top five banks worldwide. It serves 90 million customers through a network of 9,000 branches and it offers -- either directly or through subsidiaries -- a wide range of banking services. The second phase of nationalization of Indian banks took place in the year 1980. Seven more banks were nationalized with deposits over 200 crores. Till this year, approximately 80% of the banking segment in India was under Government ownership. After the nationalization of banks in India, the branches of the public sector banks rose to approximately 800% in deposits and advances took a huge jump by 11,000%. •
1955: Nationalization of State Bank of India.
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1959: Nationalization of SBI subsidiaries.
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1969: Nationalization of 14 major banks.
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1980: Nationalization of seven banks with deposits over 200 crores.
Liberalization: In the early 1990s the then Narasimha Rao government embarked on a policy of liberalisation and gave licenses to a small number of private banks, which came to be known as New Generation tech-savvy banks, which included banks such as UTI Bank (the first of such new generation banks to be set up), ICICI Bank and HDFC Bank. This move, along with the rapid growth in the economy of India, kick started the banking sector in India, which has seen rapid growth with strong contribution from all the three sectors of banks, namely, government banks, private banks and foreign banks. The next stage for the Indian banking has been setup with the proposed relaxation in the norms for Foreign Direct Investment, where all Foreign Investors in banks may be given voting rights which could exceed the present cap of 10%. The new policy shook the Banking sector in India completely. Bankers, till this time, were used to the 4-6-4 method (Borrow at 4%; Lend at 6%; Go home at 4) of functioning. The new wave ushered in a modern outlook and tech-savvy methods of working for traditional banks. All this led to the retail boom in India. People not just demanded more from their banks but also received more.
Current scenario: Public Sector Banks SBI group: State Bank of India, with its seven associate banks command the largest banking resources in India. SBI and its associate banks are: •
State Bank of India
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State Bank of Bikaner & Jaipur
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State Bank of Hyderabad
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State Bank of Indore
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State Bank of Mysore
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State Bank of Patiala
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State Bank of Saurashtra
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State Bank of Travancore
After the amalgamation of New Bank of India with Punjab National Bank, currently there are 19 nationalized banks in India: •
Allahabad Bank
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Andhra Bank
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Bank of Baroda
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Bank of India
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Bank of Maharashtra
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Canara Bank
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Central Bank of India
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Corporation Bank
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Dena Bank
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Indian Bank
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Indian Overseas Bank
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Oriental Bank of Commerce
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Punjab & Sind Bank
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Punjab National Bank
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Syndicate Bank
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Union Bank of India
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United Bank of India
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UCO Bank
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Vijaya Bank
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IDBI Bank
Private Sector Banks •
Bank of Rajasthan
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Bharat Overseas Bank
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Catholic Syrian Bank
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Centurion Bank of Punjab
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Dhanalakshmi Bank
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Federal Bank
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HDFC Bank
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ICICI Bank
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IndusInd Bank
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ING Vysya Bank
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Jammu & Kashmir Bank
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Karnataka Bank
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Karur Vysya Bank
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Kotak Mahindra Bank
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SBI Commercial and International Bank
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South Indian Bank
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Tamilnad Mercantile Bank Ltd.
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UTI Bank
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YES Bank
Foreign Banks •
ABN AMRO BANK N.V.
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Abu Dhabi Commercial Bank Ltd
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Bank of Ceylon
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BNP Paribas Bank
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Citi Bank
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China Trust Commercial Bank
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Deutsche Bank
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HSBC
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JPMorgan Chase Bank
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Standard Chartered Bank
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Scotia Bank
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Taib Bank
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Currently (2007), overall, banking in India is considered as fairly mature in terms of supply, product range and reach-even though reach in rural India still remains a challenge for the private sector and foreign banks. Even in terms of quality of assets and capital adequacy, Indian banks are considered to have clean, strong and transparent balance sheets-as compared to other banks in comparable economies in its region. The Reserve Bank of India is an autonomous body, with minimal pressure from the government. The stated policy of the Bank on the Indian Rupee is to manage volatility-without any stated exchange rate-and this has mostly been true. With the growth in the Indian economy expected to be strong for quite some timeespecially in its services sector, the demand for banking services-especially retail banking, mortgages and investment services are expected to be strong. M&As, takeovers, asset sales and much more action (as it is unravelling in China) will happen on this front in India. In March 2006, the Reserve Bank of India allowed Warburg Pincus to increase its stake in Kotak Mahindra Bank (a private sector bank) to 10%. This is the first time an investor has been allowed to hold more than 5% in a private sector bank since the RBI announced norms in 2005 that any stake exceeding 5% in the private sector banks would need to be vetted by them. Currently, India has 88 scheduled commercial banks (SCBs) - 28 public sector banks (that is with the Government of India holding a stake), 29 private banks (these do not have government stake; they may be publicly listed and traded on stock exchanges) and 31 foreign banks. They have a combined network of over 53,000 branches and 17,000 ATMs. According to a report by ICRA Limited, a rating agency, the public sector banks hold over 75 percent of total assets of the banking industry, with the private and foreign banks holding 18.2% and 6.5% respectively.
Figure 1. Structure of the organised banking sector in India. Number of banks are in brackets.
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4. RESEARCH METHODOLOGY
In this chapter, an attempt has been made to give the details regarding the research materials and methods used to achieve the research objectives. Besides research objective, it consists of need of the study, scope of the study, database and data collection methods. Also the tools of analysis and limitation of the study have been described herein.
The Present Study: Asset-liability management basically refers to the process by which an institution manages its balance sheet in order to allow for alternative interest rate and liquidity scenarios. Banks and other financial institutions provide services which expose them to various kinds of risks like credit risk, interest risk, and liquidity risk. Asset liability management is an approach that provides institutions with protection that makes such risk acceptable. Asset-liability management models enable institutions to measure and monitor risk, and provide suitable strategies for their management. It is therefore appropriate for institutions (banks, finance companies, leasing companies, insurance companies, and others) to focus on asset-liability management when they face financial risks of different types.
It is against this background that the present study “ASSET ASSET LIABILITY MANAGEMENT IN THE INDIAN BANKING SECTOR� SECTOR has been undertaken.
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5. IMPORTANCE OF STUDY.
Asset Liability Management (ALM) is a key driver of a Bank’s profitability and long term sustainability. It requires assessment of various types of risks and altering the asset liability portfolio to manage risk. 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 real banking 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 bank’s liabilities include deposits, borrowings and capital. On the other side pf 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. The post liberalization period in India saw a rapid industrial growth, which has further stimulated the fund raising activities. Over the past decade, there has been a remarkable shift in the sources of funds and its application. Funds are now being mobilized from
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investment institutions, provident funds, charitable trust, quasi-government bodies and the household sector. Even the portfolio of assets for financial intermediaries is widening. For a business, which involves trading in money, rate fluctuations invariably affect the market value, yields/costs of the assets/liabilities and a consequent impact on net interest income (NIM). Tackling this situation would have been easy in a set up where the interest rate movements are known with accuracy. However, in an economy, which is just opening out, increased capital market volatility makes predicting interest rates a rather difficult task. But risk is an inherent quality in the business of commercial banks and financial institutions. With the widened resource base, service range and client base, risk profile of these financial entities has further broadened. The most prominent financial risks to which these entities are exposed are classified into interest rate risk, liquidity risk, credit risk and forex risk. Since risk is embedded in the business of banking, its efficient management holds key to the performance of banking companies.
The income of banks comes mostly from the spreads maintained between total interest income and total interest expense. The higher the spread the more will be the NIM. There exists a direct correlation between risks and return. As a result, greater spreads only imply enhanced risk exposure. But since any business is conducted with the objective of making profits and achieving higher profitability is the target of a firm, it is the management of the risk that holds key to success and not risk elimination.
There are three different but related ways of managing financial risks. •
The first is to purchase insurance. But this is viable only for certain type of risks such as credit risks, which arise if the party to a contract defaults.
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The second approach refers to asset liability management (ALM). This involves careful balancing of assets and liabilities. It is an exercise towards minimizing exposure to risks by holding the appropriate combination of assets and liabilities so as to meet earnings target of the firm.
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The third option, which can be used either in isolation or in conjuction with the first two options, is hedging. It is to an extent similar to ALM. But while ALM involves on-balance sheet positions, hedging involves off-balance sheet positions. Products used for hedging include futures, options, forwards and swaps.
It is ALM, which requires the most attention for managing the financial performance of banks. Asset-liability management can be performed on a per-liability basis by matching a specific asset to support each liability. Alternatively, it can be performed across the balance sheet. With this approach, the net exposure of the bank’s liabilities is determined, and a portfolio of assets is maintained, which hedges those exposures. Asset-liability analysis is a flexible methodology that allows the bank to test interrelationships between a wide variety of risk factors including market risks, liquidity risks, actuarial risks, management decisions, uncertain product cycles, etc. However, it has the shortcoming of being highly subjective. It is up to the bank to decide what mix would be suitable to it in a given scenario. Therefore, successful implementation of the risk management process in banks would require strong commitment on the part of the senior management to integrate basic operations and strategic decision making with risk management.
The scope of ALM function can be described as follows: •
Liquidity risk management.
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Management of market risks.
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Trading risk management.
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Funding and capital planning
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Profit planning and growth projection.
The objective function of the risk management policy in financial entities is two fold. It aims at profitability through price matching while ensuring liquidity by means of maturity matching. Price matching aims to maintain interest spreads by ensuring that deployment of liabilities will be at a rate more than the costs. This exercise would indicate whether the institution is in a position to benefit from rising interest rates by
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having a positive gap (assets > liabilities) or whether it is in a position to benefit from declining interest rates by a negative gap (liabilities > assets). The gap between the interest rates (on assets/liabilities) can therefore be used as a measure of interest rate sensitivity. These spreads can however, be achieved if interest rate movements are known with accuracy. Similarly, grouping assets/liabilities based on their maturity profile ensures liquidity. The gap is then assessed to identify future financing requirements. However, there are often maturity mismatches, which may to a certain extent affect the expected results.
SBI- Maturity pattern for FY01 (Rs bn) Maturing within Assets Liabilities
Gap Cumulative gap
1-14 days
207
184
22
22
15-28 days
38
37
1
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29 days-3 months
95
69
27
50
>3<6 months
82
102
-20
29
>6<12 months
161
149
12
41
>1<3 years
604
1,284
-680
-639
>3<5 years
218
382
-164
-803
> 5 years
713
54
659
-144
Total (A)
2,118
2,262
-144
As can be seen from the above table, within each time bracket there are mismatches depending on cash inflows and outflows. While the mismatches upto 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 are however, expected to monitor their cumulative mismatches (running total) across all time periods by establishing internal prudential limits with the approval of the
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ALCO (asset liability committee). Thought SBI has managed a positive gap in the short tem duration, in the medium term duration (1-3 years), its liabilities are more than assets. If interest rates come down further from the current level, it would benefit by re-pricing these liabilities. The gap of Rs 680 bn is about 30% of total liabilities. In case interest rates rise, SBI is likely to see a steep fall in profitability, as over a quarter of its liabilities are not having a similar asset maturity, which could lead to a liquidity risk for the bank.
HDFC Bank- Maturity pattern for FY01 (Rs bn) Maturing within Assets Liabilities
Gap Cumulative gap
1-14 days
22
25
-3
-3
15-28 days
6
5
1
-2
29 days-3 months
31
13
18
16
>3<6 months
11
15
-4
12
>6<12 months
9
20
-11
1
>1<3 years
29
48
-19
-18
>3<5 years
7
4
4
-14
> 5 years
6
0
6
-8
Total (A)
121
129
-8
While SBI has positive gap till the one-year maturity, HDFC Bank has negative spread in the first 28 days. (As a prudent measure, banks have been advised to operate within negative gap of 20% of cash outflows during 1-14 days and 15-28 days time periods.) HDFC Bankâ&#x20AC;&#x2122;s negative spread of Rs 3 bn in the first maturity period is 12% of cash outflows. In the 1-3 year period also, its negative spread of Rs 19 bn is 15% of total liabilities. This is relatively less than that of SBI. Consequently, low risk in case of volatile interest rates. For many Indian banks, investment in securities represents a strategy of deployment of liabilities. In the absence of a variety of products, flexibility for ALM is reduced and banks tend to book profits or show losses on the securities portfolio regardless of the underlying liability. Floating rate instruments are still not popular in the Indian markets. Moreover, short selling of securities is not permitted. Further, the banking provision
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which states that banks can have only one prime lending rate (PLR) and another longterm PLR constrains effective application of ALM. However, recently banks have started lending at sub PLR to attract the borrowers. Thus, ALM technique aims to manage the volume mix, maturity, rate sensitivity, quality and liquidity of assets and liabilities as a whole. This is to attain a predetermined acceptable risk/reward ratio. ALM helps in enhancing the asset quality, quantifying the risk associated with assets and liabilities and controlling them.
In short the ALM process will involve the following steps: •
Reviewing the interest rate structure and comparing the same to the pricing of both assets and liabilities. This would help in highlighting the impending risk and the need for managing the same.
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Examining loan and investment portfolio in the light of forex and liquidity risk. Due consideration should be given to the affect of these risks on the value and cost of liabilities.
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Determining the probability of credit risk that may originate due to interest rate fluctuations or otherwise, and assess the quality of assets.
Reviewing the actual performance against the projections made. Analyzing the reasons for any affect on the spreads.
During last couple of years, liquidity risk management did not pose a challenge due to surplus liquidity in the banking system. The surplus liquidity parked by banks with Reserve Bank of India touched Rs 554.75 billion in March 2004. The deposit growth has been phenomenal whereas the credit off-take was negligible. However, since beginning of fiscal year 2004-05, the liquidity situation has changed. The loan growth of scheduled commercial banks far exceeded their deposit growth as evident from the following
Liquidity risk is often related to bank’s inability to pay to its depositors. However, a bank’s inability to pay to its depositors is the ultimate manifestation of liquidity risk.
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Liquidity risk at initial stages may lead to distress pricing of assets and liabilities. A bank with high degree of liquidity risk may be forced to borrow funds from inter bank market at exorbitant rates or has to increase its deposit rates. As the bank may not be able to transfer these increased costs to borrowers, ultimately its net interest income shall be affected. Further, as bankâ&#x20AC;&#x2122;s cost of funds goes up, increasingly it looks for risky avenues to increase its earnings. The process may lead to wrong selection of borrowers as well as venturing into risky areas (such as equity financing, giving un-secured loans etc) increasing overall risk profile of the bank. Therefore, liquidity risk has strong correlation with other risks such as interest rate risk and credit risk.
LIQUIDITY RISK MANAGEMENT Liquidity risk is measured through either stock approach or flow approach. Under stock approach, certain standard ratios are computed. Some of the ratios widely used in banks are Liquid assets to short-term liabilities, Core assets to core liabilities, Inter bank borrowings to total assets, Overnight borrowings to total assets etc. However, management of liquidity through ratios suffers from some drawbacks, as it does not factor market liquidity aspect of assets and liabilities. For example, presence of some shortterm investments may show the improved liquidity risk of the bank whereas the investment itself may be highly illiquid. Further, the ratio, though good indicator of liquidity, may be valid good for a point of time only as balance sheet profile constantly changes. Therefore, the flow approach, the alternative model for measuring and managing liquidity has been accepted by most of the banks. Under flow approach, cash flows are segregated into different maturity ladders and net funding requirement for a given time horizon is estimated. The net funding requirement over a given time horizon gives a fair idea of liquidity risk faced by an institution. Reserve Bank of India has prescribed some statutory returns for submission of data on liquidity risk and interest rate
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risk by banks. There are limits for liquidity mismatches in the first two buckets prescribed by RBI. The mismatches as percentage to outflows should not exceed negative 20% in the time buckets of 1-14 days and 15 days to 28 days.
ASSET LIABILITY MANAGEMENT IN PUBLIC SECTOR BANKS Ever since the the initiation of the process of deregulation of the Indian banking system and gradual freeing of interest rates to market forces, and consequent injection of a dose of competition among the banks, introduction of asset-liability management (ALM) in the public sector banks (PSBs) has been suggested by several experts. But, initiatives in this respect on the part of most bank managements have been absent. This seems to have led the Reserve Bank of India to announce in its monetary and credit policy of October 1997 that it would issue ALM guidelines to banks. While the guidelines are awaited, an informal check with several PSBs shows that none of these banks has moved decisively to date to introduce ALM. One reason for this neglect appears to be a wrong notion among bankers that their banks already practice ALM. As per this understanding, ALM is a system of matching cash inflows and outflows, and thus of liquidity management. Hence, if a bank meets its cash reserve ratio and statutory liquidityratio stipulations regularly without undue and frequent resort to purchased funds, it can be said to have a satisfactory system of managing liquidity risks, and, hence, of ALM. The actual concept of ALM is however much wider, and of greater importance to banks' performance. Historically, ALM has evolved from the early practice of managing liquidity on the bank's asset side, to a later shift to the liability side, termed liability management, to a still later realisation of using both the assets as well as liabilities sides of the balance sheet to achieve optimum resources management. But that was till the 1970s. In the 1980s, volatility of interest rates in USA and Europe caused the focus to broaden to include the issue of interest rate risk. ALM began to extend beyond the bank treasury to cover the loan and deposit functions. The induction of credit risk into the issue of determining adequacy of bank capital further enlarged the scope of ALM in later 1980s. In the current decade, earning a proper returnof bank equity and hence
32
maximisation of its market value has meant that ALM covers the management of the entire balance sheet of a bank. This implies that the bank managements are now expected to target required profit levels and ensure minimisation of risks to acceptable levels to retain the interest of investors in their banks. This also implies that costing and pricing policies have become of paramount importance in banks. In the regulated banking environment in India prior to the 1990s, the equation of ALM to liquidity management by bankers could be understood. There was no interest rate risk as the interest rates were regulated and prescribed by the RBI. Spreads between the deposit and lending rates were very wide (these still are considerable); also, these spreads were more or less uniform among the commercial banks and were changed only by RBI. If a bank suffered significant losses in managing its banking assets, the same were absorbed by the comfortably wide spreads. Clearly, the bank balance sheet was not being managed by banks themselves; it was being `managed' through prescriptions of the regulatory authority and the government. This situation has now changed. The banks have been given a large amount of freedom to manage their balance sheets. But the knowledge, new systems and organizational changes that are called for to manage it, particularly the new banking risks, are still lagging. The turmoil in domestic and international markets during the last few months and impending changes in the country's financial system are a grim warning to our bank managements to gear up their balance sheet management in a single heave. To begin with, as the RBI's monetary and credit policy of October 1997 recommends, an adequate system of ALM to incorporate comprehensive risk management should be introduced in the PSBs. It is suggested that the PSBs should introduce ALM which would focus on liquidity management, interest rate risk management and spread management. Broadly, there are 3 requirements to implement ALM in these banks, in the stated order: (a) developing a better understanding of ALM concepts, (b) introducing an ALM information system, and, (c) setting up ALM decisionmaking processes (ALM Committee/ALCO). The above requirements are already met by the new private sector banks, for example. These banks have their balance sheets available at the close of every day. Repeated changes in interest rates by them during the last 3 months to manage interest rate risk and their maturity mismatches are based on data provided by their MIS. In contrast, loan and deposit pricing by PSBs is based partly on
33
hunches, partly on estimates of internal macro data, and partly on their competitors' rates. Hence, PSBs would first and foremost need to focus son putting in place an ALM which would provide the necessary framework to define, measure, monitor, modify and manage interest rate risk. This is the need of the hour.
ASSET LIABILITY MANAGEMENT IN UNION BANK OF INDIA Risk Management 1.1 Risk is inherent part of Bankâ&#x20AC;&#x2122;s business. Effective Risk Management is critical to any Bank for achieving financial soundness. In view of this, aligning Risk Management to Bankâ&#x20AC;&#x2122;s organizational structure and business strategy has become integral in banking business. Over a period of year, Union Bank of India (UBI) has taken various initiatives for strengthening risk management practices. Bank has an integrated approach for management of risk and in tune with this, formulated policy documents taking into account the business requirements / best international practices or as per the guidelines of the national supervisor. These policies address the different risk classes viz., Credit Risk, Market Risk and Operational Risk. 1.2 The issues related to Credit Risk are addressed in the Policies stated below; 1.2.1 Loan Policy. 1.2.2 Credit Monitoring Policy. 1.2.3 Real Estate Policy. 1.2.4 Credit Risk Management Policy. 1.2.5 Collateral Risk Management Policy. 1.2.6 Recovery Policy.
34
1.2.7 Treasury Policy. 1.3 The Policies and procedures for Market Risks are articulated in the ALM Policy and Treasury Policy. 1.4 The Operational Risk Management involves framework for management of operational risks faced by the Bank. The issues related to this risk is addressed by; 1.4.1 Operational Risk Management Policy. 1.4.2 Business Continuity Policy. 1.4.3 Outsourcing Policy. 1.4.4 Disclosure Policy. 1.5 Besides, the above Board mandated Policies, Bank has detailed â&#x20AC;&#x2DC;Internal Control Principlesâ&#x20AC;&#x2122; communicated to the business lines for ensuring adherence to various norms like Anti-Money Laundering, Information Security, Customer complaints, Reconciliation of accounts, Book-keeping etc. 2.0 Oversight Mechanism: â&#x20AC;˘
2.1 Our Board of Directors has the overall responsibility of ensuring that adequate structures, policies and procedures are in place for risk management and that they are properly implemented. Board approves our risk management policies and also sets limits by assessing our risk appetite, skills available for managing risk and our risk bearing capacity. 2.2 Board has delegated this responsibility to a sub-committee: the Supervisory Committee of Directors on Risk Management & Asset Liability Management. This is the Apex body / Committee is responsible for supervising the risk management activities of the Bank. 2.3 Further, Bank has the following separate committees of top executives and dedicated Risk Management Department:
35
2.3.1 Credit Risk Management Committee (CRMC): This Committee deals with issues relating to credit policies and procedure and manages the credit risk on a Bank-wide basis. 2.3.2 Asset Liability Management Committee (ALCO): This Committee is the decision-making unit responsible for balance sheet planning and management from the angle of risk-return perspective including management of market risk. 2.3.3 Operational Risk Management Committee (ORMC): This Committee is responsible for overseeing Bankâ&#x20AC;&#x2122;s operational risk management policy and process. 2.3.4 Risk Management Department of the Bank provides support functions to the risk management committees mentioned above through analysis of risks and reporting of risk positions and making recommendations as to the level and degree of risks to be assumed. The department has the responsibility of identifying, measuring and monitoring the various risk faced the bank, assist in developing the policies and verifying the models that are used for risk measurement from time to time. 3.0 Credit Risk â&#x20AC;˘
3.1 Credit Risk Management Policy of the Bank dictates the Credit Risk Strategy. 3.2 These Polices spell out the target markets, risk acceptance / avoidance levels, risk tolerance limits, preferred levels of diversification and concentration, credit risk measurement, monitoring and controlling mechanisms. 3.3 Standardized Credit Approval Process with well-established methods of appraisal and rating is the pivot of the credit management of the bank. 3.4 Bank has comprehensive credit rating / scoring models being applied in the spheres of retail and non-retail portfolios of the bank.
36
3.5 The Credit rating system of the Bank has eight borrower grades for standard accounts and three grades for defaulted borrowers. 3.6 Proactive credit risk management practices in the form of studies of ratingwise distribution, rating migration, probability of defaults of borrowers, Portfolio Analysis of retail lending assets, periodic industry review, Review of Country, Currency, Counter-party and Group exposures are only some of the prudent measures, the bank is engaged in mitigating risk exposures. 3.7 The current focus is on augmenting the bank’s abilities to quantify risk in a consistent, reliable and valid fashion, which will ensure advanced level of sophistication in the Credit Risk Measurement and Management in the years ahead. 4.0 Market Risk •
4.1 Bank has well-established framework for Market Risk management with the Asset Liability Management Policy and the Treasury Policy forming the fulcrum for procedures, processes and structure. It has a major objective of protecting the bank’s net interest income in the short run and market value of the equity in the long run for enhancing shareholders wealth. The important aspect of the Market Risk includes liquidity management, interest rate risk management and the pricing of assets and liabilities. Further, Bank views the Asset Liability Management exercise as the total balance sheet management with regard to its size, quality and risk. 4.2 The ALCO is primarily entrusted with the task of market risk management. The Committee decides on product pricing, mix of assets and liabilities, stipulates liquidity and interest rate risk limits, monitors them, articulates Bank’s interest rate view and determines the business strategy of the Bank.
37
4.3 Bank has put in place a structured ALM system with 100% coverage of data on both assets and liabilities. To measure liquidity and interest rate risk, Bank prepares various reports such as Structural Liquidity, Interest Rate Sensitivity, Fortnightly Dynamic Statement etc. Besides RBI reporting many meaningful analytical reports such as Duration Gap analysis, Contingency Funding Plan, Contractual Maturity report etc. are generated at periodic intervals for ALCO, which meets regularly. Statistical and mathematical models are used to analyze the core and volatile components of assets and liabilities. 4.4 The objective of liquidity management is to ensure adequate liquidity without affecting the profitability. In tune with this, Bank ensures adequate liquidity at all times through systematic funds planning, maintenance of liquid investments and focusing on more stable funding sources. 4.5 The Mid Office group positioned in treasury with independent reporting structure on risk aspects ensure compliance in terms of exposure analysis, limits fixed and calculation of risk sensitive parameters like VaR, PV01, Duration, Defeasance Period etc. and their analysis. 5.0 Operational Risk â&#x20AC;˘
5.1 Operational Risk, which is intrinsic to the bank in all its material products, activities, processes and systems, is emerging as an important component of the enterprise-wide risk management system. Recognizing the importance of Operational Risk Management, Bank has adopted a Comprehensive Operational Risk Management Policy. This would entail the bank to move towards enhanced level of sophistication in the years ahead and to capture qualitative and quantitative measures of Operational Risk indicators in management of operational risk. 5.2 Bank has comprehensive system of internal controls, systems and procedures to monitor and mitigate risk. Bank has also institutionalized new product approval
38
process to identify the risk inherent in the new product and activities. 5.3 The Internal audit function of the Bank and the Risk Based Internal Audit, compliments the banks ability to control and mitigate risk.
6.0 Bankâ&#x20AC;&#x2122;s Preparedness to meet Basel II norms 6.1 Bank carried out a comprehensive Self-Assessment exercise spanning all the risk areas and evolved a road map to move towards implementation of Basel II as per RBIâ&#x20AC;&#x2122;s directions. The program in implementation of Risk Management, Organizational Structure, Risk measures, risk data compilation and reporting etc. is as per this laid down roadmap. 6.2 The Polices framed and procedures / practices adopted are benchmarked to the best in the industry on a continuous basis and the Bank has a clear intent to reach an advanced level
of
sophistication
in
management
of
risks
in
the
coming
year.
6.3 The ever-improving risk management practices in the Bank will result in Bank emerging stronger, which in turn would confer competitive advantage in the Market. 6.4 Bank will implement New Capital Accord w.e.f. 31/03/2008. The parallel run, till implementation, is currently underway.
RISK MANAGEMENT IN ASSET LIABILITY MANAGEMENT Categories of risk Risk in a way can be defined as the chance or the probability of loss or damage.In the case of banks, these include credit risk, capital risk, market risk, interest rate risk, and liquidity risk. These categories of financial risk require focus, since financial institutions like banks do have complexities and rapid changes in their operating environments.
39
Credit risk: The risk of counter party failure in meeting the payment obligation on the specific date is known as credit risk. Credit risk management is an important challenge for financial institutions and failure on this front may lead to failure of banks. The recent failure of many Japanese banks and failure of savings and loan associations in the 1980s in the USA are important examples, which provide lessons for others. It may be noted that the willingness to pay, which is measured by the character of the counter party, and the ability to pay need not necessarily go together. Capital risk: One of the sound aspects of the banking practice is the maintenance of adequate capital on a continuous basis. There are attempts to bring in global norms in this field in order to bring in commonality and standardization in international practices. Capital adequacy also focuses on the weighted average risk of lending and to that extent, banks are in a position to realign their portfolios between more risky and less risky assets. Market risk: Market risk is related to the financial condition, which results from adverse movement in market prices. This will be more pronounced when financial information has to be provided on a marked-to-market basis since significant fluctuations in asset holdings could adversely affect the balance sheet of banks. In the Indian context, the problem is accentuated because many financial institutions acquire bonds and hold it till maturity. When there is a significant increase in the term structure of interest rates, or violent fluctuations in the rate structure, one finds substantial erosion of the value of the securities held. Interest rate risk: Interest risk is the change in prices of bonds that could occur as a result of change: n interest rates. It also considers change in impact on interest income due to changes in the rate of interest. In other words, price as well as reinvestment risks require focus. In so far as the terms for which interest rates were fixed on deposits differed from those for which they fixed on assets, banks
40
incurred interest rate risk i.e., they stood to make gains or losses with every change in the level of interest rates. As long as changes in rates were predictable both in magnitude and in timing over the business cycle, interest rate risk was not seen as too serious, but as rates of interest became more volatile, there was felt need for explicit means of monitoring and controlling interest gaps. In most OECD countries (Harrington, 1987), the situation was no different from that which prevailed in domestic banking. The term to maturity of a bond provides clues to the fluctuations in the price of the bond since it is fairly well-known that longer maturity bonds have greater fluctuations for a given change in the interest rates compared to shorter maturity bonds. In other words commercial banks, which are holding large proportions of longer maturity bonds, will face more price reduction when the interest rates go up. 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
41
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 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. Liquidity risk: Affects many Indian institutions. It is the potential inability to generate adequate cash to cope with a decline in deposits or increase in assets. To a large extent, it is an outcome of the mismatch in the maturity patterns of assets and liabilities. First, the proportion of central government securities with longer maturities in the Indian bond market, significantly increasing during the 1970s and 1980s, affected the banking system because longer maturity securities have greater vola tility for a given change in interest rate structure. This problem gets accentuated in the context of change in the main liability structure of the banks, namely the maturity period for term deposits. For instance in 1986, nearly 50% of term deposits had a maturity period of more than 5 years and only 20%, less than 2 years for all commercial banks. But in 1992, only 17% of term deposits were more than 5 years whereas 38% were less than 2 years Risk measurement techniques There are various techniques for measuring exposure of banks to interest rate risks: 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 repricing gap that exists between the interest revenue earned 9n the bank's
42
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. Repricing gaps are calculated for assets and liabilities of differing maturities. A positive gap indicates that assets get repriced before liabilities, whereas, a negative gap indicates that liabilities get repriced before assets. The bank looks at the rate 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. 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) The 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
43
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 . 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 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 . 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
44
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, 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 modeling, it makes sense to stick to simpler types of analysis. Asset-liability management strategies for correcting mismatch The strategies that can be employed for correcting the mismatch in terms of D(A) > D(L) can be either liability or asset driven. Asset driven strategies for correcting the mismatch focus on shortening the duration of the asset portfolio. The commonly employed asset based financing strategy is securitization. Typically the long-term asset portfolios like the lease and hire purchase portfolios are securitized; and the resulting proceeds are either redeployed in short term assets or utilized for repaying short-term liabilities. Liability driven strategies basically focus on lengthening the maturity profiles of liabilities. Such strategies can include for instance issue of external equity in the form of additional equity shares or compulsorily convertible preference shares (which can also help in augmenting the Tier I capital of finance companies), issue of redeemable preference shares, subordinated debt instruments, debentures and accessing long term debt like bank borrowings and term loans. Strategies to be employed for correcting a mismatch in the form of D(A) < D(L) (which will be necessary if interest rates are expected to decline) will be the reverse of the strategies discussed above. Asset driven strategies focus on lengthening the maturity profile of assets by the deployment of available lendable resources in long-term assets such as lease and hire purchase. Liability driven strategies focus on shortening the maturity profile of liabilities, which can include, liquidating bank borrowings which are primarily in the form of cash credit (and hence amenable for immediate liquidation), using
45
the prepayment options (if any embedded in the term loans); and the call options, if any embedded in bonds issued by the company; and raising short-term borrowings (e.g.: fixed deposits with a tenor of one year) to repay long-term borrowings. 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 systems in place. The following points bring out the reasons as to why asset-liability management is necessary in the Indian context: . In the context of a bank, asset-liability management refers to the process of managing the net interest margin (NIM) within a given level of risk. NIM = Net Interest Income/Average Earning Assets = NII/AEA Since NIl equals interest income minus interest expenses, Sinkey (1992) suggests that NIM can be viewed as the spread on earning assets and uses the term spread management. As the basic objective of banks is to maximize income while reducing their exposure to risk, efficient management of net interest margin becomes essential. . Several banks have inadequate and inefficient management systems that have to be altered so as to ensure that the banks are sufficiently liquid. . Indian banks are now more exposed to the vagaries of the international markets, than ever before because of the removal of restrictions, especially with respect to forex transactions. Asset-liability management becomes essential as it enables the bank to maintain its exposure to foreign currency fluctuations given the level of risk it can handle. . An increasing proportion of investments by banks is being recorded on a marked-to-market basis and as such large portion of the investment portfolio is exposed to market risks. Countering the adverse impact of these changes is possible only through efficient asset-liability management techniques. . As the focus on 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.
46
Traditionally, banks and insurance companies used accrual accounting for essentially all their assets and liabilities. They would take on liabilities, such as deposits, life insurance policies or annuities. They would invest the proceeds from these liabilities in assets such as loans, bonds or real estate. All assets and liabilities were held at book value. Doing so disguised possible risks arising from how the assets and liabilities were structured. Consider a bank that borrows USD 100MM at 3.00% for a year and lends the same money at 3.20% to a highly-rated borrower for 5 years. For simplicity, assume interest rates are annually compounded and all interest accumulates to the maturity of the respective obligations. The net transaction appears profitableâ&#x20AC;&#x201D;the bank is earning a 20 basis point spreadâ&#x20AC;&#x201D;but it entails considerable risk. At the end of a year, the bank will have to find new financing for the loan, which will have 4 more years before it matures. If interest rates have risen, the bank may have to pay a higher rate of interest on the new financing
than
the
fixed
3.20
it
is
earning
on
its
loan.
Suppose, at the end of a year, an applicable 4-year interest rate is 6.00%. The bank is in serious trouble. It is going to be earning 3.20% on its loan and paying 6.00% on its financing. Accrual accounting does not recognize the problem. The book value of the loan
(the
bank's
100MM(1.032) The
book
= value
of
100MM(1.030)
the
asset)
is:
103.2MM. financing
=
(the
bank's
[1] liability)
103.0MM.
is: [2]
Based upon accrual accounting, the bank earned USD 200,000 in the first year. Market value accounting recognizes the bank's predicament. The respective market values
of
100MM(1.030)
the
bank's =
asset
and 103.0MM.
liability
are: [4]
From a market-value accounting standpoint, the bank has lost USD 10.28MM. So which result offers a better portrayal of the bank' situation, the accrual accounting profit or the market-value accounting loss? The bank is in trouble, and the market-value loss reflects this. Ultimately, accrual accounting will recognize a similar loss. The bank
47
will have to secure financing for the loan at the new higher rate, so it will accrue the asyet
unrecognized
loss
over
the
4
remaining
years
of
the
position.
The problem in this example was caused by a mismatch between assets and liabilities. Prior to the 1970's, such mismatches tended not to be a significant problem. Interest rates in developed countries experienced only modest fluctuations, so losses due to assetliability mismatches were small or trivial. Many firms intentionally mismatched their balance sheets. Because yield curves were generally upward sloping, banks could earn a spread
by
borrowing
short
and
lending
long.
Things started to change in the 1970s, which ushered in a period of volatile interest rates that continued into the early 1980s. US regulation Q, which had capped the interest rates that banks could pay depositors, was abandoned to stem a migration overseas of the market for USD deposits. Managers of many firms, who were accustomed to thinking in terms of accrual accounting, were slow to recognize the emerging risk. Some firms suffered staggering losses. Because the firms used accrual accounting, the result was not so much bankruptcies as crippled balance sheets. Firms gradually accrued the losses over the
subsequent
5
or
10
years.
One example is the US mutual life insurance company the Equitable. During the early 1980s, the USD yield curve was inverted, with short-term interest rates spiking into the high teens. The Equitable sold a number of long-term guaranteed interest contracts (GICs) guaranteeing rates of around 16% for periods up to 10 years. During this period, GICs were routinely for principal of USD 100MM or more. Equitable invested the assets short-term to earn the high interest rates guaranteed on the contracts. Short-term interest rates soon came down. When the Equitable had to reinvest, it couldn't get nearly the interest rates it was paying on the GICs. The firm was crippled. Eventually, it had to demutualize
and
was
acquired
by
the
Axa
Group.
Increasingly, managers of financial firms focused on asset-liability risk. The problem was not that the value of assets might fall or that the value of liabilities might rise. It was that
48
capital might be depleted by narrowing of the difference between assets and liabilitiesâ&#x20AC;&#x201D; that the values of assets and liabilities might fail to move in tandem. Asset-liability risk is a leveraged form of risk. The capital of most financial institutions is small relative to the firm's assets or liabilities, so small percentage changes in assets or liabilities can translate into large percentage changes in capital. Exhibit 1 illustrates the evolution over time of a hypothetical company's assets and liabilities. Over the period shown, the assets and liabilities change only slightly, but those slight changes dramatically reduce the company's capital (which, for the purpose of this example, is defined as the difference between assets and liabilities). In Exhibit 1, the capital falls by over 50%, a development that would threaten almost any institution.
Example: Asset-Liability Risk Exhibit 1
Asset-liability risk is leveraged by the fact that the values of assets and liabilities each tend to be greater than the value of capital. In this example, modest fluctuations in values of assets and liabilities result in a 50% reduction in capital.
Accrual accounting could disguise the problem by deferring losses into the future, but it could not solve the problem. Firms responded by forming asset-liability management (ALM) departments to assess asset-liability risk. They established ALM committees comprised of senior managers to address the risk. Techniques for assessing asset-liability risk came to include gap analysis and duration analysis. These facilitated techniques of gap management and duration matching of assets and liabilities. Both approaches worked well if assets and liabilities comprised fixed cash flows. Options, such as those embedded in mortgages or callable debt, posed problems that gap analysis could not address. Duration analysis could address these in theory, but implementing sufficiently sophisticated duration measures was problematic. Accordingly, banks and insurance companies also performed scenario analysis
49
With scenario analysis, several interest rate scenarios would be specified for the next 5 or 10 years. These might specify declining rates, rising rate's, a gradual decrease in rates followed by a sudden rise, etc. Scenarios might specify the behavior of the entire yield curve, so there could be scenarios with flattening yield curves, inverted yield curves, etc. Ten or twenty scenarios might be specified in all. Next, assumptions would be made about the performance of assets and liabilities under each scenario. Assumptions might include prepayment rates on mortgages or surrender rates on insurance products. Assumptions might also be made about the firm's performance—the rates at which new business would be acquired for various products. Based upon these assumptions, the performance of the firm's balance sheet could be projected under each scenario. If projected performance was poor under specific scenarios, the ALM committee might adjust assets or liabilities to address the indicated exposure. A shortcoming of scenario analysis is the fact that it is highly dependent on the choice of scenarios. It also requires that many assumptions be made about how specific assets or liabilities will perform under
specific
scenarios.
In a sense, ALM was a substitute for market-value accounting in a context of accrual accounting. It was a necessary substitute because many of the assets and liabilities of financial institutions could not—and still cannot—be marked to market. This spirit of market-value accounting was not a complete solution. A firm can earn significant markto-market profits but go bankrupt due to inadequate cash flow. Some techniques of ALM —such as duration analysis—do not address liquidity issues at all. Others are compatible with cash-flow analysis. With minimal modification, a gap analysis can be used for cash flow analysis. Scenario analysis can easily be used to assess liquidity risk. Firms recognized a potential for liquidity risks to be overlooked in ALM analyses. They also recognized that many of the tools used by ALM departments could easily be applied to assess liquidity risk. Accordingly, the assessment and management of liquidity risk became a second function of ALM departments and ALM committees. Today, liquidity risk
management
is
generally
considered
a
part
of
ALM.
50
ALM has evolved since the early 1980's. Today, financial firms are increasingly using market-value accounting for certain business lines. This is true of universal banks that have trading operations. For trading books, techniques of market risk management— value-at-risk (VaR), market risk limits, etc.—are more appropriate than techniques of ALM. In financial firms, ALM is associated with those assets and liabilities—those business lines—that are accounted for on an accrual basis. This includes bank lending and deposit taking. It includes essentially all traditional insurance activities. Techniques of ALM have also evolved. The growth of OTC derivatives markets have facilitated a variety of hedging strategies. A significant development has been securitization, which allows firms to directly address asset-liability risk by removing assets or liabilities from their balance sheets. This not only eliminates asset-liability risk; it
also
frees
up
the
balance
sheet
for
new
business.
Information technology and asset-liability management in the Indian context 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. It also helps in terms of quicker decision-making from the central office since branches are networked and accounts are considered as belonging to the bank rather than a branch. The electronic fund transfer system as well as demat holding of securities also significantly alters mechanisms of implementing asset-liability 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,
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facilitates cross-bank initiatives in asset-liability management to reduce aggregate unit cost. This 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. . Reducing the maturity mismatch so as to avoid liquidity problems. . Managing funds with respect to crucial factors like size and duration.
RECLASSIFICATION OF ASSETS & LIABILITIES The 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
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meaningless. The relevant data has been collected from the RBI website.
RESULT AND ANALYSIS CANONICAL CORRELATION ANALYSIS Multivariate statistical technique, canonical correlation has been used to access the nature and strength of relationship between the assets and liabilities. To explore the relationship between assets and liabilities, we could merely compute the correlation between each set of assets and each set of liabilities. Unfortunately, all of these correlations assess the same hypothesis - that assets influence liabilities. Hence, a Bonferroni adjustment needs to be applied. That is, we should divide the level of significance by the number of correlations. This Bonferroni adjustment, of course, reduces the power of each correlation and thus can obscure the findings. Canonical correlation provides a means to explore all of the correlations concurrently and thus obviates the need to incorporate a Bonferroni adjustment. The technique reduces the relationship into a few significant relationships. The essence of canonical correlation Measures the strength of relationship between two sets of variables (Assets (6) & Liabilities (4) in this case) by establishing linear combination of variables in one set and a linear combinations of variables in other set. It produces an output that shows the strength of relationship between two variates as well as individual variables accounting for variance in other set. A = A1 * (Liquid Assets) + A2 * (SLR Securities) + A3 * (Investments) + A4 * (Term Loans) + A5 * (Short Term Loans) + A6 * (Fixed Assets) B = B1 * (Net Worth) + B2* (Borrowings) + B3 * (Short Term Deposits) + B4 * (Long Term Deposits) To begin with, A and B (called canonical variates) are unknown. The technique tries to compute the values of Ai and Bi such that the covariance between A & B is maximum.
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The first row (R2) is a measure of the significance of the correlation. In this case all the correlations are significant. The canonical loading is a measure of the strength of the association i.e. it is the percent of variance linearly shared by an original variable with one of the canonical variates. A loading greater that 40% is assumed to be significant. A negative loading indicates an inverse relationship. For example, for Foreign Banks, Fixed Assets (FA) under Assets has a loading of -0.903 and Net Worth (NW) under liabilities has a loading of -0.664. Since both are negative this means there is a strong correlation between FA and NW. Similarly for Foreign Banks, we can observe that there is a strong negative correlation between short term deposit with both Term Loan and Fixed Asset.
OBSERVATIONS As per the summary table above, the canonical co-relation coefficients of different set of banks indicate that different banks have different degree of association among constituents of assets and liabilities. Bank-Groups can be arranged in decreasing order of correlation: – SBI & Associates – Private Banks – Nationalized Banks – Foreign Banks Redundancy factors indicate how redundant one set of variables is, given the other set of variable which gives an idea about independent and dependent sets. This also gives an idea about the fact that whether the bank is asset managed or liability managed. Looking at the redundancy factors, the independent and dependent sets for different bank- groups can be identified:
Other than foreign bank groups, all other three have asset as their independent set. These
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banks were actively managing assets and liability was dependent upon how well the assets are managed. This is in perfect consonance with the macro indicators. The interest rates were coming down all these years and banks were busy in parking their assets in different avenues where they could get maximum return. Lately, the scenario has changed in terms of interest rates. Now as there is ample liquidity in the market, banks especially the bigger one is not concerned about the liability. They can always borrow from active money market to manage their liability. Foreign Banks The canonical function coefficient or the canonical weight of different constituents in case of foreign banks Term Loans and Fixed Assets form asset side and Net Worth and Short Term Deposit from liability side have significant presence with following interpretation: • Very strong co-relation between Fixed Asset and Net Worth. • Strong negative correlation between short term deposit with both Term Loan and Fixed Asset. This indicates• Proper usage of short term deposit. • Not used for long term assets or long term loans.
Private Banks In case of private banks all constituents of assetside Liquid Assets, SLR Securities, Short Term Loans, Investments, Term Loans, and Fixed Asset are significantly explaining the co-relation while on liability side only Net Worth and Short Term Deposit are contributing. This shows how actively these banks manage their asset to generate maximum return. This relationship can be interpreted in the following ways: • Very strong co-relation between FA and NW. • Short Term Deposits is used for Liquid Assets, SLR and Short Term Loans. As defined above LA, SLR and STL – all are highly liquid section of assets. So it is very prudent to employ short term deposit. • Borrowings are used for Investment and Term Loans. As defined, borrowings are
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near maturity liability while investment and term loans are of long term maturity. So the private banks are using risky strategy of deploying short term fund in long term investment which is clearly against right asset-liability management. Under normal circumstances long term investment gives better returns, so this strategy is to generate additional profitability at the cost of liquidity. However as the money market has become more matured, it is easy to manage liquidity without much of risk. Nationalized Banks In case of nationalized banks Investment, short term loan, fixed asset contribute significantly in explaining asset part while net worth and borrowings constituent of liability is major factor. The major interpretations are: • Very strong co-relation between FA and NW. • Nationalized banks use Borrowings for Short Term Loans. • There is negative co-relation between Borrowings and investment. • More concerned with liquidity than profitability • Conservative strategy ( in comparison to Private Banks) • Good short term maturity/liquidity management Nationalized banks use a borrowing (which is near term maturity) for short term a loan which is effective way of ALM. However nationalized banks deploy long term liability in short term assets. This is distinctly different from private banks strategy. The nationalized banks are more concerned about liquidity than profitability.
SBI & Associates For SBI group all constituents of Liability namely Net worth, borrowings, short term deposits and long term deposits are significant while in assets side SLR investment, Investments, Term loans and fixed assets are significant. Following can be interpreted: • Very strong correlation between FA and NW • Strong correlation between Borrowings and STL. • Correlation between Long term Deposits and ‘Term Loans, Investment and SLR’.
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• Short Term Deposits and Short Term Liabilities are correlated. • Most Conservative strategy • Over concerned with liquidity • Use Long term funds for Long as well as medium & short term loans Among all bank-groups, SBI & Associates seem to be most prudent asset liability management as short term liability is matched with short term asset and long term assets is matched with long term liability. But at the same time, this group deploy long term fund for medium and short term loans. This can be called over concerned with liquidity and that too by paying a price in terms of less profitability by foregoing the opportunity to deploy them in long term assets. PROFITABILITY ANALYSIS OF BANKS As discussed above, private banks are more aggressive in managing their portfolio for better profit realization. So let us look into the profitability of these banks and relate that to their ALM. For this all banks are divided into two groups- Public and Private. Nationalized along with SBI are clubbed together as public banks while foreign and private banks are clubbed together as private banks. The profit figures can be compared in terms of Net Profit Margin, Return on Net Worth and Equity Multiplier. Following graph depicts the comparison The above comparison shows that till 2002, private banks were better in terms of profitability indicators. The aggressive strategy adopted by them in terms of deploying asset for long term is being reflected in the better profitability as compared to public sector banks. Since 2002, the public banks have caught up with private banks. This can be due to second generation banking reforms, deregulation and more autonomy given to the banks in terms of directed credit and regulated interest rates.
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CONCLUSION
Based on discussion above, it can be concluded that ownership and structure of the banks do affect their ALM procedure. The discussion paper concludes with following findings: • Among all groups, SBI & Associates have best asset- liability maturity pattern. • They have the best correlation between assets and liabilities • Other than Foreign Banks - all other banks can be called liability managed banks. • They all borrow from money market to meet their maturing liabilities • Across all banks Fixed Asset and Net Worth are highly correlated • All banks have proportionate Net worth and investment in Fixed Asset • Private banks are aggressive in profit generation • Use short term fund (cheaper) for long term investments • Risky strategy in case of liquidity problem or rising interest rate scenario • Nationalized banks (including SBI &Associates) are excessively concerned about Liquidity • Even surplus short tem deposits they don’t use it for long term • Use Long term funds for Long as well as medium & short term loans • Conservative Approach which is reflected in their lower profitability • The aggressive strategy adopted by private banks is being reflected in terms
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of better profitability. â&#x20AC;˘ Private Banks have better Net Profit Margin and. Return on Net worth. â&#x20AC;˘ Private Banks have greater equity multiplier than public sector banks which reflects extra leverage that they have. â&#x20AC;˘ After 2002, public sector banks are catching up with private banks. It is also important to note that the conglomerate approach to financial institutions, which is increasingly becoming popular in the developed markets, could also get replicated in Indian situations. This implies that the distinction between commercial banks and 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, as well as other activities like mutual funds, insurance and pension funds. In such a situation, the strategy for asset-liability management becomes more challenging because one has to adopt a modular approach in terms of meeting asset liability management requirements of different divisions and product lines. But it also provides opportunities for diversification across activities that could facilitate risk management on an enhanced footing. In other words, in the Indian context, the challenge could arise from say the merger of SBI, IDBI, and LIC. Such a scenario need not be considered extremely hypothetical because combined and stronger balance sheets provide much greater access to global funds. It also enhances the capability of institutions to significantly alter their risk profiles at short notice because of the flexibility afforded by the characteristics of products of different divisions. This also requires significant managerial competence in order to have a conglomerate view of such organizations and prepare it for the challenges of the coming decade. As long as the artificial barriers between different financial institutions exist, asset liability management is narrowly focussed and many a time not in a position to achieve the desired objectives. This is because of the fact that the institutional arrangements are mainly due to historical reasons of convenience and a perceived
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static picture of the operating world. The integration of different financial markets, instruments and institutions provide greater opportunities for emerging markets like India to aim for higher return in the context of minimizing risk. Hence, it maybe appropriate to think in terms of reorienting our institutional structures (removing the distinctions between commercial banks, non-banking financial companies, and term lending institutions to start with) and having a conglomerate regulatory framework for monitoring capital adequacy, liquidity. solvency, marketability, etc. This will go a long way in ironing out the mismatches between the assets and the liabilities, rather than narrowly focussed asset-liability management techniques for individual banks. The scope of ALM activities has widened. Today, ALM departments are addressing (nontrading) foreign exchange risks and other risks. Also, ALM has extended to non-financial firms. Corporations have adopted techniques of ALM to address interest-rate exposures, liquidity risk and foreign exchange risk. They are using related techniques to address commodities risks. For example, airlines' hedging of fuel prices or manufacturers' hedging of steel prices are often presented as ALM.
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8.PROBLEMS OF THE STUDY.
•
Time constraint
Shortage of time was a very big constraint due more facts and figures were not included in the study. •
Resource constraint
Availability of data was a constraint due to which only few banking data is considered which is available and also there are some banks whose data was not available so their duration was shortened. •
Period of analysis
Generally longer period gives us a more accurate estimate of performance. •
Complex calculation
Though every precaution has taken due to large data and complex calculations there may be chances of error.
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9. BIBLIOGRAPHY
Websites www.rbi.org.in www.yahoofinance.org www.wikipedia.com www.businessworldonline.com www.google.com (search engine) www.msn.com www.economictimes.com Other References: Books 1. Pandey, I. M, Financial Management, Edition- 2004, New Delhi. Journals
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1.Outlook Money 2.India today
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