Assets and Liability Management

28/07/2020 0 By indiafreenotes

Asset liability management (ALM) can be defined as the comprehensive and dynamic framework for measuring, monitoring and managing the financial risks associated with changing interest rates, foreign exchange rates and other factors that can affect the organization’s liquidity.

Asset and liability management (often abbreviated ALM) is the practice of managing financial risks that arise due to mismatches between the assets and liabilities as part of an investment strategy in financial accounting.

ALM sits between risk management and strategic planning. It is focused on a long-term perspective rather than mitigating immediate risks and is a process of maximising assets to meet complex liabilities that may increase profitability.

ALM includes the allocation and management of assets, equity, interest rate and credit risk management including risk overlays, and the calibration of company-wide tools within these risk frameworks for optimisation and management in the local regulatory and capital environment.

Often an ALM approach passively matches assets against liabilities (fully hedged) and leaves surplus to be actively managed.

The concept of asset/liability management focuses on the timing of cash flows because company managers must plan for the payment of liabilities. The process must ensure that assets are available to pay debts as they come due and that assets or earnings can be converted into cash. The asset/liability management process applies to different categories of assets on the balance sheet.

Evolution of ALM in Indian Banking System

 In view of the regulated environment in India in 1970s to early 1990s, there was no interest rate risk as the interest rate were regulated and prescribed by RBI. Spreads between deposits and lending rates were very wide.  At that time banks Balance Sheets were not being managed by banks themselves as they were being managed through prescriptions of the regulatory authority and the government.  With the deregulation of interest rates,  banks were given a large amount of  freedom to manage their Balance sheets.   Thus, it became necessary to introduce ALM guidelines so that banks can be prevented from big losses on account of wide ALM mismatches.

Reserve Bank of India issued its first ALM Guidelines in February 1999, which was made effective from 1 st April 1999.  These guidelines covered, inter alia, interest rate risk and liquidity risk measurement/ reporting framework and prudential limits. Gap statements were required to be  prepared by scheduling all assets and liabilities according to the stated or anticipated re-pricing date or maturity date.  The Assets and Liabilities at this stage were required to be divided into 8 maturity buckets (1-14 days; 15-28 days; 29-90 days; 91-180 days; 181-365 days, 1-3 years and 3-5 years and above 5 years), based on the remaining period to their maturity (also called residual maturity)..    All the liability figures were to be considered as outflows while the asset figures were considered as inflows.

As a measure of liquidity management, banks were required to monitor their cumulative mismatches across all time buckets in their statement of structural liquidity by establishing internal prudential limits with the approval of their boards/ management committees. As per the guidelines, in the normal course, the mismatches (negative gap) in the time buckets of 1-14 days and 15-28 days were not to exceed 20 per cent of the cash outflows in the respective time bucket.

 Later on RBI made it mandatory for banks to form ALCO (Asset Liability Committee) as a Committee of the Board of Directors to track, monitor and report ALM.    

It was in September, 2007, in response to the international practices and to meet the need for a sharper assessment of the efficacy of liquidity management and with a view to providing a stimulus for development of the term-money market, RBI fine tuned  these guidelines and it was provided that  the banks may adopt a more granular approach to measurement of liquidity risk by splitting the first time bucket (1-14 days at present) in the Statement of Structural Liquidity into three time buckets viz., 1 day (called next day) , 2-7 days and 8-14 days.   Thus, banks were asked to put their maturing asset and liabilities in 10 time buckets.

Thus as per  October 2007 RBI guidelines, banks were advised that the net cumulative negative mismatches during the next day, 2-7 days, 8-14 days and 15-28 days should not exceed 5%, 10%, 15% and 20% of the cumulative outflows, respectively, in order to recognize the cumulative impact on liquidity. Banks were also advised to undertake dynamic liquidity management and prepare the statement of structural liquidity on a daily basis. In the absence of a fully networked environment, banks were allowed to compile the statement on best available data coverage initially but were advised to make conscious efforts to attain 100 per cent data coverage in a timely manner.     Similarly, the statement of structural liquidity was to be reported to the Reserve Bank, once a month, as on the third Wednesday of every month. The frequency of supervisory reporting of the structural liquidity position was increased to fortnightly, with effect from April 1, 2008. Banks are now required to submit the statement of structural liquidity as on the first and third Wednesday of every month to the Reserve Bank.

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

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

Progress in Adoption of Techniques of ALM by Indian Banks

ALM process involve in identification, measurement and management of risk Parameter. In its original guidelines RBI asked the banks to use traditional techniques like Gap analysis for monitoring interest rates and liquidity risk. At that RBI desired  that Indian Banks slowly move towards sophisticated techniques like duration , simulation and Value at risk in future.  Now with the passage of time, more and more banks are moving towards these advanced techniques.

Asset- Liability Management Techniques

ALM is bank specific control mechanism, but it is possible that several banks may employ similar ALM techniques or each bank may use unique system.

Gap Analysis

Gap Analysis is a technique of Asset – Liability management . It is used to assess interest rate risk or liquidity risk. It measures at a given point of time the gaps between Rate  Sensitive Liabilities (RSL) and Rate Sensitive Assets (RSA) (including off balance sheet position) by grouping them into time buckets according to residual maturity or next re-pricing period , whichever is earlier. An asset or liability is treated as rate sensitive if;

(i) Within time bucket under consideration is a cash flow.

(ii) The interest rate resets/reprices contractually during time buckets

(iii) Administered rates are changed and

(iv) It is contractually pre-payable or withdrawal allowed before contracted maturities.

 Thus;

 GAP = RSA-RSL

GAP Ratio = RSAs/RSL

  • Mismatches can be positive or negative
  • Positive Mismatch: M.A.>M.L. and vice-versa for Negative Mismatch
  • In case of +ve mismatch, excess liquidity can be deployed in money market instruments, creating new assets & investment swaps etc.
  • For –ve mismatch,it can be financed from market borrowings(call/Term),Bills rediscounting, repos & deployment of foreign currency converted into rupee.