Sign up for Equitymaster's free daily newsletter, The 5 Minute WrapUp and get access to our latest Multibagger guide (2017 Edition) on picking money-making stocks.

This is an entirely free service. No payments are to be made.

Download Now Subscribe to our free daily e-letter, The 5 Minute WrapUp and get this complimentary report.
We hate spam as much as you do. Check out our Privacy Policy and Terms Of Use.
ALM: Tightrope walking - Views on News from Equitymaster
  • E-MAIL
  • A  A  A
  • Nov 30, 2001

    ALM: Tightrope walking

    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 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.

    • 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.

    • 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.

    • Management of market risks.

    • Trading risk management.

    • Funding and capital planning

    • 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 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 23
    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 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 Bank’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 which states that banks can have only one prime lending rate (PLR) and another long-term 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.

    • 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.

    • 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.

    As Alan Greenspan, Chairman of the US Federal Reserve observed, ‘risk taking is a necessary condition for wealth creation’. Risk arises as a deviation between what happens and what was expected to happen. Banks are no exception to this phenomenon. As a result managements have to create efficient systems to identify, measure and control the risk and ALM is just one component of the overall cluster.



    Equitymaster requests your view! Post a comment on "ALM: Tightrope walking". Click here!


    More Views on News

    IDFC Bank: Strong Trading Income Shields Credit Slowdown (Quarterly Results Update - Detailed)

    Aug 10, 2017

    IDFC Bank is taking steps to address contracting NIMs and successfully transition in to a retail bank.

    ICICI Bank: Loan Slippages Trending Downwards (Quarterly Results Update - Detailed)

    Aug 10, 2017

    Asset quality will be the key thing to watch out for going forward.

    Axis Bank: Outside Watchlist Slippages a Big Worry (Quarterly Results Update - Detailed)

    Jul 31, 2017

    Almost 74% of the watchlist as provided by the bank of Rs 226 billion in FY16 has turned into non-performing assets.

    Should You Take SBI Chief's Advice and Load up on SBI Shares? (The 5 Minute Wrapup)

    Jul 6, 2017

    Does the stock score on the value versus price equation?

    AU Small Finance Bank Ltd. (IPO)

    Jun 27, 2017

    Should one subscribe to the IPO of AU Small Finance Bank Ltd?

    More Views on News

    Most Popular

    A 'Backdoor' to Multibaggers: It's Like Investing in Asian Paints Ten Years Ago(The 5 Minute Wrapup)

    Aug 10, 2017

    Don't miss these proxy bets on growing companies or in a few years you will be looking back with regret.

    The Most Profitable Investment in the History of the World(Vivek Kaul's Diary)

    Aug 8, 2017

    'Yes, it looks like a bubble. And, yes, it's like buying a lottery ticket. But there's something happening that has never happened before. It's an evolutionary leap in money itself.'

    Should You Invest In Bharat-22 ETF? Know Here...(Outside View)

    Aug 8, 2017

    Bharat-22 is one of the most diverse ETFs offered so far by the Government. Know here if you should invest...

    Signs of Life in the India VIX(Daily Profit Hunter)

    Aug 12, 2017

    The India VIX is up 36% in the last week. Fear has gone up but is still low by historical standards.

    Bitcoin Continues Stellar Rise(Chart Of The Day)

    Aug 10, 2017

    Bitcoin hits an all-time high, is there more upside left?

    Copyright © Equitymaster Agora Research Private Limited. All rights reserved.
    Any act of copying, reproducing or distributing this newsletter whether wholly or in part, for any purpose without the permission of Equitymaster is strictly prohibited and shall be deemed to be copyright infringement.

    LEGAL DISCLAIMER: Equitymaster Agora Research Private Limited (hereinafter referred as 'Equitymaster') is an independent equity research Company. Equitymaster is not an Investment Adviser. Information herein should be regarded as a resource only and should be used at one's own risk. This is not an offer to sell or solicitation to buy any securities and Equitymaster will not be liable for any losses incurred or investment(s) made or decisions taken/or not taken based on the information provided herein. Information contained herein does not constitute investment advice or a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual subscribers. Before acting on any recommendation, subscribers should consider whether it is suitable for their particular circumstances and, if necessary, seek an independent professional advice. This is not directed for access or use by anyone in a country, especially, USA or Canada, where such use or access is unlawful or which may subject Equitymaster or its affiliates to any registration or licensing requirement. All content and information is provided on an 'As Is' basis by Equitymaster. Information herein is believed to be reliable but Equitymaster does not warrant its completeness or accuracy and expressly disclaims all warranties and conditions of any kind, whether express or implied. Equitymaster may hold shares in the company/ies discussed herein. As a condition to accessing Equitymaster content and website, you agree to our Terms and Conditions of Use, available here. The performance data quoted represents past performance and does not guarantee future results.

    SEBI (Research Analysts) Regulations 2014, Registration No. INH000000537.

    Equitymaster Agora Research Private Limited. 103, Regent Chambers, Above Status Restaurant, Nariman Point, Mumbai - 400 021. India.
    Telephone: +91-22-61434055. Fax: +91-22-22028550. Email: info@equitymaster.com. Website: www.equitymaster.com. CIN:U74999MH2007PTC175407

    Become A Smarter Investor In
    Just 5 Minutes

    Multibagger Stocks Guide 2017
    Get our special report, Multibagger Stocks Guide (2017 Edition) Now!
    We will never sell or rent your email id.
    Please read our Terms


    Aug 21, 2017 03:37 PM