Call risk also includes the need to be able to undertake new transactions when desirable. There are micro and macro level objectives of ALM. At micro level, the objective functions of the ALM are two-fold. It aims at profitability through price matching while ensuring liquidity by means of maturity matching. Price matching basically aims to maintain spreads by ensuring that the deployment of liabilities will be at a rate higher than the costs.
The gap is then assessed identify the future financing requirements. This ensures liquidity. However, maintaining profitability by matching prices and ensuring liquidity by matching the maturity levels is not an easy task. The following tables explain the process involved in price matching and maturity matching. At macro-level, ALM leads to the formulation of critical business policies, efficient allocation of capital and designing of products with appropriate pricing strategies.
A typical strategy of a bank to generate revenue is to run mismatch, i. To address this risk and to make sure a bank does not expose itself in excessive mismatch, a bucket-wise e. However, as most deposits and loans of a bank matures next day call, savings, current, overdraft etc. As a result, banks prepare a forecasted balance sheet where the assets and liabilities of the nature of current, overdraft etc. The distribution of core and non-core is determined through historical trend, customer behavior, statistical forecasts and managerial judgment; the core balance can be put into over 1 year bucket whereas non-core can be in days or 3 months bucket.
Strategic framework: The Board of Directors are responsible for setting the limits for risk at global as well as domestic levels. They have to decide how much risk they are willing to take in quantifiable terms. Also it is necessary to determine who is in chare of controlling risk in the organization and their responsibilities. Organizational framework: All elements of the organization like the ALM Committee, sub—committees, etc.
ALM activities should be supported by the top management with proper resource allocation and personnel committee. Operational framework: There should be a proper direction for risk management with detailed guidelines on all aspects of ALM. The policy statement should be well articulated providing a clear direction for ALM function.
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Analytical framework: Analytical methods in ALM require consistency, which includes periodic review of the models used to measure risk to avoid miscalculation and verifying their accuracy. Various analytical components like Gap, Duration, Stimulation and Value-at-Risk should be used to obtain appropriate insights. Technology framework: An integrated technological framework is required to ensure all potential risks are captured and measured on a timely basis. It would be worthwhile to ensure that automatic information feeds into the ALM systems and he latest software is utilized to enable management perform extensive analysis, planning and measurement of all facets of the ALM function.
Performance reporting framework: The performance of the traders and business units can easily be measured using valid risk measurement measures. The performance measurement considers approaches and ways to adjust performance measurement for the risks taken. The profitability of an institution comes from three sources: Asset, Liabilities and their efficient management. Regulatory compliance framework: The objective of regulatory compliance element is to ensure that there is compliance with the requirements, expectations and guidelines for risk — based capital and liquidity ratios.
Control framework: The control framework covers the control over all processes and systems. The emphasis should be on setting up a system of checks and balances to ensure the integrity of data, analysis and reporting. ALM Information Systems 2. ALM Organization 3. A good information system gives the bank management a complete picture of the bank's balance sheet. Considering the large network of branches and the lack of an adequate system to collect information required for ALM which analyses information on the basis of residual maturity and behavioral pattern it will take time for banks in the present state to get the requisite information.
In respect of foreign exchange, investment portfolio and money market operations, in view of the centralized nature of the functions, it would be much easier to collect reliable information. The data and assumptions can then be refined over time as the bank management gain experience of conducting business within an ALM framework.
The spread of computerization will also help banks in accessing data. Pillar II: ALM Organization The board should have overall responsibility for the management of risks and should decide the risk management policy of the bank and set the limits for liquidity, interest rate, foreign exchange and equity price risk. The responsibility of ALM is on the treasury department of the banks.
The Alco committee comprising of the senior management of bank is responsible for Balance Sheet risk management. The size of ALCO varies from organization to organization. CEO heads the committee.
The objective of the ALCO is to derive the most appropriate strategy for the banks in terms of the mix of assets and liabilities given its expectation for the future and the potential consequences of interest-rate movements, liquidity constraints, foreign exchange exposure and capital adequacy.
The RBI in its guidelines has asked Indian banks to use traditional techniques like Gap Analysis for monitoring interest rate and liquidity risk. For the accrued portfolio, most Indian Private Sector banks use Gap analysis, but are gradually moving towards duration analysis. Most of the foreign banks use duration analysis and are expected to move towards advanced methods. The ALM desk consisting of operating staff should be responsible for analyzing, monitoring and reporting the risk profiles to the ALCO.
The staff should also prepare forecasts simulations showing the effects of various possible changes in market conditions related to the balance sheet and recommend the action needed to adhere to bank's internal limits. The ALCO is a decision making unit responsible for balance sheet planning from risk- return perspective including the strategic management of interest rate and liquidity risks.
Each bank will have to decide on the role of its ALCO, its responsibility as also the decisions to be taken by it. The business issues that an ALCO would consider, inter alia, will include product pricing for both deposits and advances, desired maturity profile of the incremental assets and liabilities, etc. In addition to monitoring the risk levels of the bank, the ALCO should review the results of and progress in implementation of the decisions made in the previous meetings. The ALCO would also articulate the current interest rate view of the bank and base its decisions for future business strategy on this view.
In respect of the funding policy, for instance, its responsibility would be to decide on source and mix of liabilities or sale of assets. Towards this end, it will have to develop a view on future direction of interest rate movements and decide on a funding mix between fixed vs floating rate funds, wholesale vs retail deposits, money market vs capital market funding, domestic vs foreign currency funding, etc.
Individual banks will have to decide the frequency for holding their ALCO meetings. In addition the Head of the Information Technology Division should also be an invitee for building up of MIS and related computerization. Some banks may even have sub-committees. The size number of members of ALCO would depend on the size of each institution, business mix and organizational complexity.
Funds management represents the core of sound bank planning and financial management.
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Although funding practices, techniques, and norms have been revised substantially in recent years, it is not a new concept. Funds management is the process of managing the spread between interest earned and interest paid while ensuring adequate liquidity. Therefore, funds management has following three components, which have been discussed briefly.
New loan demands, existing commitments, and deposit withdrawals are the basic contractual or relationship obligations that a bank must meet. Liquidity Tracking Measuring and managing liquidity needs are vital for effective operation of the Company. The importance of liquidity transcends individual institutions, as liquidity shortfall in one institution can have repercussions on the entire system. The ALCO should measure not only the liquidity positions of the Company on an ongoing basis but also examine how liquidity requirements are likely to evolve under different assumptions.
Experience shows that assets commonly considered being liquid, such as govt. Therefore, liquidity has to be tracked through maturity or cash flow mismatches. For measuring and managing net funding requirement, the use of a maturity ladder and calculation of cumulative surplus or deficit of funds at selected maturity dates is adopted as a standard tool. Historical Funding requirement b. Current liquidity position c. Anticipated future funding needs d. Sources of funds e.
Options for reducing funding needs f. Present and anticipated asset quality g. Present and future earning capacity and h. Present and planned capital position To satisfy funding needs, a bank must perform one or a combination of the following: a. Dispose off liquid assets b. Increase short term borrowings c. Decrease holding of less liquid assets d. Increase liability of a term nature e. Increase Capital funds Statement of Structural Liquidity It Places all cash inflows and outflows in the maturity ladder as per residual maturity.
Maturity Liabilities are cash outflow and Maturity Assets are cash inflows. It shows the structure as of a particular date.
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Banks can fix the tolerance level for other maturity buckets. Assets and Liabilities to be reported as per their maturity profile into 8 maturity buckets: a. Over 3 months and up to 6 months e. Over 1 year and up to 3 years g. Over 3 years and up to 5 years h. Liquid assets enable a bank to provide funds to satisfy increased demand for loans. But banks, which rely solely on asset management, concentrate on adjusting the price and availability of credit and the level of liquid assets. However, assets that are often assumed to be liquid are sometimes difficult to liquidate.
For example, investment securities may be pledged against public deposits or repurchase agreements, or may be heavily depreciated because of interest rate changes. Furthermore, the holding of liquid assets for liquidity purposes is less attractive because of thin profit spreads. To maximize profitability, management must carefully weigh the full return on liquid assets yield plus liquidity value against the higher return associated with less liquid assets. Income derived from higher yielding assets may be offset if a forced sale, at less than book value, is necessary because of adverse balance sheet fluctuations.
Seasonal, cyclical, or other factors may cause aggregate outstanding loans and deposits to move in opposite directions and result in loan demand, which exceeds available deposit funds. A bank relying strictly on asset management would restrict loan growth to that which could be supported by available deposits. The decision whether or not to use liability sources should be based on a complete analysis of seasonal, cyclical, and other factors, and the costs involved. In addition to supplementing asset liquidity, liability sources of liquidity may serve as an alternative even when asset sources are available.
This does not preclude the option of selling assets to meet funding needs, and conceptually, the availability of asset and liability options should result in a lower liquidity maintenance cost. The alternative costs of available discretionary liabilities can be compared to the opportunity cost of selling various assets.
The major difference between liquidity in larger banks and in smaller banks is that larger banks are better able to control the level and composition of their liabilities and assets. When funds are required, larger banks have a wider variety of options from which to select the least costly method of generating funds. The ability to obtain additional liabilities represents liquidity potential. The marginal cost of liquidity and the cost of incremental funds acquired are of paramount importance in evaluating liability sources of liquidity. Consideration must be given to such factors as the frequency with which the banks must regularly refinance maturing purchased liabilities, as well as an evaluation of the bank's ongoing ability to obtain funds under normal market conditions.
Changes in money market conditions may cause a rapid deterioration in a bank's capacity to borrow at a favorable rate. The access to discretionary funding sources for a bank is always a function of its position and reputation in the money markets. Although the acquisition of funds at a competitive cost has enabled many banks to meet expanding customer loan demand, misuse or improper implementation of liability management can have severe consequences.
Further, liability management is not riskless. This is because concentrations in funding sources increase liquidity risk.
For example, a bank relying heavily on foreign interbank deposits will experience funding problems if overseas markets perceive instability in U. Replacing foreign source funds might be difficult and costly because the domestic market may view the bank's sudden need for funds negatively. Again over-reliance on liability management may cause a tendency to minimize holdings of short-term securities, relax asset liquidity standards, and result in a large concentration of short-term liabilities supporting assets of longer maturity.
During times of tight money, this could cause an earnings squeeze and an illiquid condition. Also if rate competition develops in the money market, a bank may incur a high cost of funds and may elect to lower credit standards to book higher yielding loans and securities. If a bank is purchasing liabilities to support assets, which are already on its books, the higher cost of purchased funds may result in a negative yield spread.
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Preoccupation with obtaining funds at the lowest possible cost, without considering maturity distribution, greatly intensifies a bank's exposure to the risk of interest rate fluctuations. That is why banks that particularly rely on wholesale funding sources, management must constantly be aware of the composition, characteristics, and diversification of its funding sources.
Credit risk traditionally has been and still is the biggest risk faced by this sector and has been addressed through various central bank relations and guidelines. However, given the state of data availability most bank ALCOs are not able to hold meaningful discussions on balance sheet risks. Discussions in most ALCOs that do meet regularly are oriented towards treasury activity rather than taking a view of the entire balance sheet. This is again mainly due to lack of data on the other businesses of the bank.
However, given the increasing volatility in interest and exchange rates it is becoming critical for banks to manage their market risks. A look at the regulatory guidelines in the more developed markets on ALM could provide clues to the main features of any guidelines that may be introduced by the RBI. As per the guidelines, the mismatches negative gap during the time buckets of days and days in the normal course are not to exceed 20 per cent of the cash outflows in the respective time buckets.
Next day, days and days. Banks may, however, make concerted and requisite efforts to ensure coverage of per cent data in a timely manner. The format of Statement of Structural Liquidity has been revised suitably and is furnished at Annex I. The guidance for slotting the future cash flows of banks in the revised time buckets has also been suitably modified and is furnished at Annex II. The format of the Statement of Short-term Dynamic Liquidity may also be amended on the above lines. To enable the banks to fine tune their existing MIS as per the modified guidelines, the revised norms as well as the supervisory reporting as per the revised format would commence with effect from the period beginning January 1, and the reporting frequency would continue to be monthly for the present.
However, the frequency of supervisory reporting of the Structural Liquidity position shall be fortnightly, with effect from the fortnight beginning April 1, Policy: Lack of a coherent, documented and practical policy is a big hindrance to ALM implementation. Most often, ALCO membership itself may not be aware of implications of risks being measured and impact. Policies should address all issues concerning the bank, all policies should be clearly explained to all members of board, apart from ALCO and these must be documented.
Proper revisions to this document, a quarterly review needs to be organized as well as parameters may be changing due to change in situations. Understanding of complexities: Many people in a bank need to understand risk measurements and risk mitigation procedures. Measurement of risk is a fairly simple phenomenon and does go on regardless.
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Bank Asset Liability Management (ALM) – A quick review of ALM strategies
Subjects Business Nonfiction. Banks are a vital part of the global economy, and the essence of banking is asset-liability management ALM. This book is a comprehensive treatment of an important financial market discipline.