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Asset Liability Management
Banks hold different categories of assets and liabilities with different maturities carrying different interest rates. The bank’s ability in matching this asset and liability structure results in improving its returns. Asset liability management involves managing different risks such as interest rate risk, credit risk, operational risk, exchange rate risk, market risk, liquidity risk, contingency risk and treasury management risk.
Variations in interest rates will impact the value of assets and liabilities that a bank holds. Therefore they need to devise tools and techniques to handle the impact of these changes. Interest rate risk management helps in maximizing bank profits and reduces losses and protects bank assets. The nature of banks having a smaller capital base compared to the larger asset base makes banks vulnerable to capital erosion due to reduction in value of assets.
Bank balance sheet before capital erosion
Liabilities Assets
Capital 20000 Reserves 85000
Borrowings 10000 Advances 588000
Short term deposits 550000 Investments 100000
Long term deposits 200000 Fixed Assets 7000
Total 780000 Total 780000
Bank balance sheet after capital erosion on account of 2% value reduction in advances shows a 58.8% reduction in capital.
Liabilities Assets
Capital 8240 Reserves 85000
Borrowings 10000 Advances 576240
Short term deposits 550000 Investments 100000
Long term deposits 200000 Fixed Assets 7000
Total 768240 Total 768240
There are several models of risk management through asset liability management. They are asset models, liability models, randomness models, multi‐dimensional models and computer aided asset
liability management (CALM) models. Asset models and liabilities models focus on one aspect of the balance sheet. The randomness model is based on selected criteria that impact the bank performance. Multi‐dimensional models look at impact of selected variables on several independent variables. The CALM models are comprehensive and aim at dynamic asset liability management.
In managing risks banks need to focus attention on volume, mix, maturity, rate sensitivity, quality and liquidity and acceptable risk reward ratio. The parameters for ALM are net interest margin, market value of equity and economic equity ratio.
Reserve Bank of India has provided guidelines in terms of asset liability management. The traditional approach focuses on operational limits on credit, loan provisioning, portfolio diversification and collateralization. The innovative methods suggested include loan securitization, capital adequacy and derivative products.
For successful risk management by banks, well developed money market, trading in repo transactions, forward trading, underwriting facilities and derivative markets are essential.
Gap Analysis
The technique used by banks to analyze the impact of interest rate changes on the assets, liabilities and net worth. Gap is the difference between rate sensitive asset and rate sensitive liabilities. A negative gap is associated with increase in interest rates and a positive gap is associated with decline in interest rates. Estimated loss is computed with reference to value change within each time bucket and aggregate difference between assets and liabilities.
Liabilities Assets
Rate Sensitive Liabilities Rate Sensitive Assets
Fixed Rate Liabilities Fixed Rate Assets
Total Total
A positive funds gap shows financing of rate sensitive assets by fixed rate liabilities. A negative funds gap on the other hand shows fixed rate assets financed by rate sensitive liabilities.
Example
Liabilities Assets
Rate Sensitive Liabilities Rate Sensitive Assets
Short term deposits 550000 Advances 145000
shorten asset maturities. If on the other hand interest rates are falling, a reverse action will be initiated.
Duration Analysis
Duration analysis aims at maximizing market value of equity. Duration is computed taking weighted average of cash flows of an instrument discounted to present time. Duration gap is computed subtracting weighted liabilities duration from asset duration. The weights are computed by dividing total liabilities by total assets.
Duration analysis assumes precise knowledge of duration of assets and liabilities, market value of assets, a flat interest rate structure, no impact of convexity on valuation and a parallel shift in the change of interest rates.
Computation of duration gap
Assets Liabilities
T Bill Investment Certificate of Deposit
1 year 7% 30 1 year 6% 50
Loan 2 year 10% 70 3 Year Time Deposit 8% 40
Capital 10
When rates increase by 2%
Assets Discounted Cash Flows
T Bill : 32.
(1 + 0.09)
- Loan: 7.00 = 6. - 77.00 = 61.
- Asset Value 97.
- 1 Year CD = 54. Liabilities Discounted Cash Flows - 50. (1 + 0.08)
- 3 Year TD = 3.60 = 3. - = 3.60 = 2. (1 + 0.11) - (1 + 0.11) - = 43.60 = 31. - (1 + 0.11) - 38.
- Total Liabilities 88.
- Market Value of Bank Capital (97.63 – 88.04) 9.
- Additional Income - (-20 x 0.02) 0.
- Decline in Capital Value of Bank (10 – 9.59 – 0.40) 0.
- Book Value of Bank Capital 10.
Decline in Equity Value (Duration Gap) ‐0.
Summary of impact of duration gap on changing interest rate scenarios can be stated as follows.
Duration Gap
Interest rate Change
Assets Liabilities Equity
Positive Increase Decrease > Decrease Decrease
Positive Decrease Increase > Increase Increase
Negative Increase Decrease < Decrease Increase
Negative Decrease Increase < Increase Decrease
Zero Increase Decrease = Decrease No change
Zero Decrease Increase = Increase No change
Immunization is the process of achieving a zero duration gap. Immunization of bank portfolio is optimum when the gain from the higher reinvestment rate is offset by capital loss and the change in capital is insensitive to changes in interest rate fluctuations.
Derivatives in ALM
Financial derivative instruments are instruments of risk management used by banks for hedging expected variations in returns or values. Some of the derivative instruments used by banks to hedge their interest rate risk are forward rate agreements, futures, options, swaps, caps, floors and collars. Forward rate agreements are contracts where a bank anticipating increase or decrease in interest rates enters into a contract with counterparty for exchange of values at predetermined rates. Futures are similar contracts where banks take position to settle contracts at current rates on a future date. These contracts are marked to market and are for a fixed duration. Options are contracts that provide a right to buy or sell at an agreed rate an instrument on a future date. Caps, floors and collars provide the upper and lower limits for interest rate fluctuations which triggers a contract on the banks. Swaps aim at exchange of fixed rate instruments to fluctuating rate instruments at predetermined rates on a future date.
Swaps
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Some of the causes for risk from off balance sheet activities include contingent liabilities, guarantees, standby letters of credit, loan commitments and note issue facilities given by banks. Securitization of loan wherein a debt instrument is issued by a bank based on expected revenues from a defined pool of loans is a strategy used by banks to transfer loan risks to market.
Hedging
- Example ‐ Interest‐rate forward contract
- Purchase of T‐Bills with a maturity of one year.
Advantages
- Risk of increased interest rate is reduced
- Flexibility can be incorporated in the contract if they are traded in the Over‐The‐ Counter (OTC) market.
Disadvantages
- OTC contracts have less liquidity
- Default risk to the bank
Questions
1. What is asset liability management?
2. Explain the steps in asset liability management process.
3. What is gap analysis? How is it performed?
4. What is duration analysis? Explain the methodology.
5. How is interest rate risk managed by banks?
6. What are derivatives?
7. How are derivatives used by banks for interest rate risk management?
8. What are off balance sheet items? What type of risks banks face in holding off
balance sheet items?
9. What are the assumptions behind duration analysis?
10. Discuss the technique of interest rate risk management used by bank.
11. Determine the gap for a bank with an asset sensitive value of 49 crore and liability
sensitive value of 120 core.
12. Determine if a bank is conservative or aggressive if it has a positive gap position.
