• NOVEMBER 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 withinAssets Liabilities   GapCumulative gap
1-14 days2071842222
15-28 days3837123
29 days-3 months95692750
>3<6 months82102-2029
>6<12 months1611491241
>1<3 years6041,284-680-639
>3<5 years218382-164-803
> 5 years71354659-144
Total (A)2,1182,262-144 

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 withinAssets Liabilities   Gap Cumulative gap
1-14 days2225-3-3
15-28 days651-2
29 days-3 months31131816
>3<6 months1115-412
>6<12 months920-111
>1<3 years2948-19-18
>3<5 years744-14
> 5 years606-8
Total (A)121129-8 

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.

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