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WEST BENGAL UNIVERSITY OF TECHNOLOGY SUMMER PROJECT REPORT ASSET LIABILITY MANAGEMENT AT UCO BANK BY SUBARNA GUPTA WBUT ROLL NO.: 08136009013 WBUT REGN NO.: 081360710098 ARMY INSTITUTE OF MANAGEMENT

KOLKAT A

ASSET LIABILITY MANAGEMENT 2009

ASSET LIABILITY MANAGEMENT

2

SUBARNA GUPTA

ASSET LIABILITY MANAGEMENT

2009

CONTENTS Serial

Topic

Page No

I.

Guidance-cum-completion certificate

7

II.

Acknowledgement

8

III. IV.

Executive Summary Corporate Profile

9 11

V.

Purpose and scope of study

14

VI.

Methodology

14

VII.

Project Details

15

1. 1.1. 1.2. 2. 2.1. 3.

Introduction Definition of risk Relation between risk and return Risk in context of banking sector Types of Risks Risk Management

16 16 16 17 17 21

3.1.

21

3.2.

Key Factors in the evolution of financial institution risk management practice Steps involved in risk management

3.3.

Techniques of risk management

22

Asset Liability Management

23

4.1.

Definition

23

4.2.

Importance of ALM

23

4.3.

Significance of ALM

24

4.4.

Parameters for stabilizing ALM

24

5.

ALM Organizational Structure

25

5.1.

Composition of ALCO

25

5.2. 5.3. 5.4. 5.5. 6. 7. 7.1.

The Mid Office The Dealing Room The Back Office Functions of ALM: Roles & Responsibilities ALM Process Management of Liquidity Risk Adequacy of liquidity position of a bank

25 26 26 27 28 35 37

7.2.

Sources of liquidity risk

37

4.

3

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2009

7.3.

Types of liquidity risk

37

7.4.

Measuring and managing market risk

38

7.5.

Case study on dynamic liquidity

41

7.6.

Structural liquidity statement

43

Management of Interest Rate Risk

44

8.1.

Types of Interest rate risk

47

8.2.

Effects of Interest rate risk

51

8.3.

Interest rate risk management techniques

51

8.4.

Sound interest rate risk management principles

52

Management of Exchange Rate Risk

53 54 55

9.3.

Types of exchange risk Tools and techniques of managing foreign exchange risk Steps in forex risk management

9.4.

Strategies for foreign exchange management

58

10.

Fund Transfer Pricing

59

11.

Value at Risk (VaR) & Duration based ALM

61

11.1.

The idea behind VaR

61

11.2.

Methods of calculating VaR

61

11.3.

Uses of VaR

62

Importance of IT and software in ALM

63

A Typical ALM System

64

Collection and Analysis of Data

68

13.1.

ALM: A Bank’s Case Study

69

13.2.

Data Analysis

69

Findings and recommendations

71

14.1.

Liquidity under crisis scenario

71

14.2.

Estimation of liquidity under market crisis scenario

72

15.

Conclusion

73

16. 17. 18. 19. 20.

Constraints and limitations Scope of further study Annexure I Annexure II Bibliography

74 74 75 80 83

8.

9 9.1. 9.2.

12. 12.1. 13.

14.

4

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LIST OF TABLES Serial

Topic

Page no.

1

Organizational structure (UCO Bank)

13

2

Some probable risk scenario

20

3

ALM History

23

4

Composition of Liquid Fund

36

5

Dynamic liquidity structure of ABC Bank

42

6

Expected balance sheet of hypothetical bank

45

7

1% increase in short term rates: Expected balance sheet of hypothetical bank

46

8

1% decrease in short term rates: Expected balance sheet of hypothetical bank

46

9

Proportionate doubling in size: Expected balance sheet of hypothetical bank

46

10

Increase in RSAs and decrease in RSLs: Expected balance sheet of hypothetical bank

47

11

Statement showing impact of changing interest rates on repricing assets and liabilities

48

12

Relation between interest rate changes and their impact on NII

49

13

Interest sensitive gap position of 1-30 days bucket of XYZ bank and Net impact on NII under changed scenario

49

14

Table showing yield curve risk involved as the spread between two maturities of Treasury Bills is narrowed

50

15

Fund Management Profit Centre: The liability, credit and mismatch spreads of a bank

60

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LIST OF FIGURES

Serial

Topic

Page no.

1

Graph showing risk return trade-off

16

2

Flow of information towards decision making in ALM

29

3

Impact of hedging on expected cash flows of the firm

54

4

Conceptual comparison on differences among Operating, Transaction and Translation foreign exchange exposure

55

5

Framework of Foreign Exchange Risk Management

57

6

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ASSET LIABILITY MANAGEMENT 2009

CERTIFICATE This is to certify that Ms SUBARNA GUPTA, WBUT Registration. No 081360710098 of ARMY INSTITUTE OF MANAGEMENT, undertaken

WBUT

the

Roll

project

No titled

08136009013 “ASSET

has

LIABILITY

MANAGEMENT” under our guidance from 8th of June 09 to 21st of July 09 at UCO BANK, Head Office and has completed the said project successfully.

External Guide’s Full Signature

ORGANIZATION’S SEAL

Designation

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ACKNOWLEDGEMENT It is with immense pride and satisfaction that I present this project titled ‘ASSET LIABILITY MANAGEMENT’ studied and developed at UCO BANK, Head Office, and Kolkata. I would also like to thank Mr. S. Mishra, Assistant General Manager, HR Department for allowing me to pursue my Summer Internship Project in UCO Bank. UCO Bank deserves a very special mention for providing generous support in the preparation of this report. I accord my humble thanks to Mr. D. P Chatterjee, General Manager, Inspection & Risk Management and Late Mr. R.K. Jain, Assistant General Manager, Risk Management for their unforgettable help, kind encouragement and providing me the idea to select the topic. I feel elevated in expressing my gratitude and indebtness to Mr. Gopala Krishnan, Chief Officer of Risk Department (Industry Guide) for his sincere guidance, sustained interest and incessant encouragement throughout the course of preparation. I would like to sincerely thank Mr. S. Senthil Kumaram and Mr. Pranab Biswas for their kind help in the initial days of my internship right from introducing the topic to guiding me and making me aware of all possible guidelines which are used in Asset Liability Management and their encouragement. I shall be failing in my duty if I do not thank Professor Kousik Guhathakurta (College Guide) of my college, Army Institute of Management, Kolkata for his direct and indirect helps during preparation of my report. It was a very fruitful learning experience and involved interaction with various people both in and out of the bank. I would also like to thank the staff members of Risk Management Department for providing me the valuable thoughts and inputs in order to make my study affluent. I take this opportunity to declare my utmost sincere gratitude to my affectionate parents for their blessings and encouragement for the successful completion of this project. Lastly there are many well wishers, friends and dear ones who directly and indirectly rendered with valuable help to complete this professional endeavor. I have deep sense of reverence for all of them. The greatest of this credit goes to the blessing bestowed upon me by the Lord without whose yearning; I could not have even moved a step forward.

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ExEcutive Summary As Alan Greenspan, Chairman of the US Federal Reserve observed, ‘risk taking is a necessary condition for wealth creation’. Risk arises as a negative 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 provides the overall picture of the asset liability profile of an institution. The objective of ALM is to maximize returns through efficient fund allocation and maturity mismatch management given an acceptable risk structure. ALM is a multidimensional process, requiring simultaneous interactions among different dimensions. Increased globalization and large volume of cross border financial transactions pose a significant challenge in effectively managing the asset liability of any institution, particularly, commercial bank. The post Lehman scenario where credit risk culminated into liquidity risk provided the required insight for all banks across the world to take a relook at reassessing their asset liability profile. Under these circumstances, managing asset and liability to achieve the desired corporate objective with manageable and known risk is gathering currency. This particular scenario provided a necessary impetus for undertaking this project. UCO bank, one of the oldest and major commercial banks in India, introduced the ALM process under the RBI guidelines. This project involves detailed study of the ALM- its various aspects, the process, how it is practiced in the bank. This includes management of liquidity risk, foreign exchange rate risk and interest rate risk- their respective techniques and processes. The project begins with introducing risk and risk management which includes the factors behind evolution of financial institution risk management practice, the steps involved in risk management (i.e. identification, measurement and mitigation of risk) and the techniques of risk management. Asset liability management arises from the inherent nature of term intermediation of maturing assets and liabilities. It involves mainly liquidity risk and interest rate risk which along with default possibility (credit risk) leads to challenges for cash flow management and to sustain the expectation of the stake holders. Interest rate risk normally means adverse changes in the interest income due to market volatility or interest rate volatility which ultimately affects the value of bank’s assets, liabilities and off-balance sheet items. In this project interest rate risk management initially involved understanding the changes in Net Interest Income under various

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situations of change in interest rate and then the types of interest rate risk are detailed and interest rate risk management techniques and practices are discussed. Besides, the project also includes overview of Foreign exchange risk management, fund transfer pricing and the role of IT and software in ALM. Finally, to have a detailed understanding of Structural liquidity and its impact on ALM practices, a case study is developed. Due to the sensitive nature of data, a hypothetical structural liquidity has been developed based on which an earnest effort has been made to understand the asset and liability profile. In terms of the RBI regulations bank and market specific scenario were applied on the hypothetical structural liquidity and resultant position has been analyzed. Based on the outcome, possible courses of action have also been indicated. Statement of structural liquidity under normal scenario Cumulative mismatch as percentage to cumulative outflows Prudential limits

Day 1

287.43 % -5.00%

2-7 Days

94.03% -10.00%

8-14 Days

15-28 Days

83.37% -15.00%

38.51% -20.00%

29 Days & upto 3 Months -9.34% -30.00%

Over 3 months & upto 6 Months -8.09%

Over 6 Months & upto 1 Yr

Over 3 Yr & upto 3 Yrs

-20.71%

-17.82%

-30.00%

-35.00%

-30.00%

Over 3 Yrs & upto 5 Yrs -8.15%

Above 5 Yrs

-15.00%

-10.00%

In the normal situation it was found that the bank has cumulative mismatch as percentage of cumulative outflows ratios well within the prudential limits provided by RBI and that the bank is dealing with short-term assets and long-term liabilities. It could be concluded that 1. A conservative approach may be followed by the bank i.e. to hold funds rather than deploy it so that it does not bear the risk to be a defaulter of payment. 2. There is no proactive asset management in place in the bank. 3. It is presumed that the bank has got the perception that interest rate will rise and so it is not willing to lock funds in the long term to maximize the opportunity gain. 4. The bank has got decent deposit profile between 1-3 years bucket which shows the confidence customers have in the bank. Thus, although the bank has a comfortable liquidity position in the long term, it may improve on its asset position in the long term by suitable deployment of funds so that opportunity loss is minimized and NII is improved. Suggestions to improve on asset management are: 1. Deploy funds in loan portfolio. 2. Deploy funds in floating rate government or corporate bonds. Investments in floating rate bonds minimize the risk as floating rate bonds can be hedged and two situations can be there:

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-1.40%

ASSET LIABILITY MANAGEMENT 2009



If the interest rate rises then the bank should not do anything as it is receiving float and paying fixed.



If the interest rate falls, then the bank can hedge through Interest Rate Swap (IRS) and receive fixed and pay float.

An investment under Government securities in fixed interest rate bonds also involves two situations: •

If the interest rate rises, the bank may receive float and pay fixed.



If the interest rate falls, then the bank may do nothing and continue to receive fixed and pay float.

3. Deploy funds in floating rates linked with loans and advances. Considering the reverse situation, in the normal scenario we get Statement of structural liquidity under normal scenario Cumulative mismatch as % to cumulative outflows Prudential limits

Day 1

-287.43%

-5.00%

2-7 Days

-94.03%

-10.00%

8-14 Days -83.37%

-15.00%

15-28 Days -38.51%

-20.00%

29 Days & upto 3 Months 9.34%

-30.00%

Over 3 months & upto 6 Months 8.09%

Over 6 Months & upto 1 Yr

Over 3 Yr & upto 3 Yrs

20.71%

17.82%

-30.00%

-35.00%

-30.00%

Over 3 Yrs & upto 5 Yrs 8.15%

Above 5 Yrs

-15.00%

-10.00%

1.40%

It is found that the bank has leveraged short term liabilities with long term assets and has strain in its immediate liquidity position. The bank has bridged the prudential limits and is a completely outlier facing serious liquidity risk problems. The options available to the bank are: 1. Bank may liquidate its assets i.e. loans and investments taking into account the cost involved. 2. Bank may sell its investments even at loss considering the situation. 3. Bank may go for securitizations i.e. sell its loan portfolio. 4. Bank may tap known resources at very attractive rates for borrowing for 1 or 3 years or 3-6 month’s period. Statement of structural liquidity under bank specific crisis scenario Cumulative mismatch as % to cumulative outflows Prudential limits (Normal Scenario)

Day 1

2-7 Days

8-14 Days

15-28 Days

29 Days & upto 3 Months

Over 6 Months & upto 1 Yr

Over 3 Yr & upto 3 Yrs

-35.53%

Over 3 months & upto 6 Months -31.15%

-75.23%

-58.98%

-45.63%

-36.34%

-5.00%

-10.00%

-15.00%

-20.00%

Above 5 Yrs

-27.80%

Over 3 Yrs & upto 5 Yrs -14.04%

-39.72%

-30.00%

-30.00%

-35.00%

-30.00%

-15.00%

-10.00%

Applying the regulator’s assumptions for bank specific crisis scenario it was found that the situation was quite grave with negative cumulative mismatch percentages beyond the prudential limits in all but the last 3 maturity buckets. The bank has more RSLs than RSAs in all the buckets and will be benefitted if the interest rate decreases.

11

SUBARNA GUPTA

-6.35%

ASSET LIABILITY MANAGEMENT 2009

Thus, the possible options available to the bank are emergency borrowing for 1-2 months at a slightly higher rate than the prevailing market rate of interest, to raise the interest rate suitably over and above the competitors to attract short term depositors, RBI acting as the last resort of the bankers through liquidity adjustment facilities like reverse repo, etc. Again, RBI may provide the bank with the liquidity support at the bank rate under Collateralized Lending Facility (CLF) Bank may utilize the Export Refinance Facilities provided by RBI to tide over temporary liquidity need. The bank may avoid taking additional commitment, may judicially dispose its long-term investments at a minimum cost, may sell its loan portfolio to other banks to raise funds, may try to borrow from some of its clients with whom they enjoy good relations or may use relationship with correspondent banks for short term requirements subject to prudential limits of 25% of Tier I capital. Statement of structural liquidity under market specific scenario Cumulative mismatch as % to cumulative outflows Prudential limits (Normal Scenario)

Day 1

2-7 Days

8-14 Days

15-28 Days

29 Days & upto 3 Months

Over 6 Months & upto 1 Yr

Over 3 Yr & upto 3 Yrs

-20.99%

Over 3 months & upto 6 Months -17.92%

-45.98%

-30.41%

-14.00%

-8.34%

-5.00%

-10.00%

-15.00%

-20.00%

Above 5 Yrs

-19.23%

Over 3 Yrs & upto 5 Yrs -4.90%

-31.10%

-30.00%

-30.00%

-35.00%

-30.00%

-15.00%

-10.00%

Lastly, applying the regulator’s assumptions for market specific crisis scenario, it was found that though there are negative mismatch percentages beyond the prudential limits, the situation is not as grave as the bank specific crisis situation. Under these circumstances, the options available to the bank are to approach RBI for liquidity or RBI may tweak – the CRR and or SLR as it happened during the Dec’08 Quarter to infuse liquid funds/liquidity into the system. Again, RBI can increase refinance facility. Thus, it could be concluded that the bank exercises an overall conservative approach which, if made more flexible to an extent, will help the bank better cope with either crisis situations or mere fluctuations in the market.

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1.67%

ASSET LIABILITY MANAGEMENT 2009

CORPORATE PROFILE Founded in 1943, UCO Bank is a commercial bank and a Government of India Undertaking. Its Board of Directors consists of government representatives from the Government of India and Reserve Bank of India as well as eminent professionals like accountants, management experts, economists, businessmen, etc. Vision Statement To emerge as the most trusted, admired and sought-after world class financial institution and to be the most preferred destination for every customer and investor and a place of pride for its employees. Mission Statement To be a Top-class Bank to achieve sustained growth of business and profitability, fulfilling socio-economic obligations, excellence in customer service; through up gradation of skills of staff and their effective participation making use of state-of-the-art technology. Global banking has changed rapidly and UCO Bank has worked hard to adapt to these changes. The bank looks forward to the future with excitement and a commitment to bring greater benefits to you. UCO Bank, with years of dedicated service to the Nation through active financial participation in all segments of the economy - Agriculture, Industry, Trade & Commerce, Service Sector, Infrastructure Sector etc., is keeping pace with the changing environment. With a countrywide network of more than 2000 service units which includes specialized and computerized branches in India and overseas, UCO Bank has marched into the 21st Century matched with dynamism and growth! Overview The bank is in the Service of Community since 1943. The bank has nearly 2000 Service Units spread all over India. It also operates in two Major International Financial Centers namely Hong Kong and Singapore. UCO Bank has its Correspondents/Agency arrangements all over the world. The bank undertakes Foreign Exchange Business in more than 50 Centers in India.

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Strengths Country-wide presence Overseas Presence with Profitable Overseas Operations Strong Capital Base High Proportion of Long Term Liabilities A Well Diversified Asset Portfolio A Large and Diversified Client Base Fully Computerized Branches at Major Centers Branch representation in Top 100 Centers (as per deposits) in the country Organization Structure Headquartered in Kolkata, the Bank has 35 Regional Offices spread all over India. Branches located in a geographical area report to the Regional Office having jurisdiction over that area. These Regional Offices are headed by Senior Executives ranging up to the rank of General Manager, depending on size of business and importance of location. The Regional Offices report to General Managers functioning at Head Office in Kolkata. Commitment to Customers In all their promotional activities, the bank is fair and reasonable in highlighting the salient features of the schemes marketed by them. Misleading or unfair highlighting of any aspect of any scheme/service marketed by the Bank leading to unfair practice is not resorted to by the Bank. In their continuing endeavor to serve their customers better, the UCO Bank has considerably extended the business hours for public transaction at the branches on all week-days. The bank has also introduced a number of NO HOLIDAY branches. These branches are open all 365 days a year. Besides, several of the branches have Express DD Counter from where Demand Drafts can be purchased without any waiting time. Products & Services NRI Banking Foreign Currency Loans Finance/Services to Exporters Finance/Services to Importers Remittances Forex & Treasury Services Resident Foreign Currency (Domestic) Deposits Correspondent Banking Services General Banking Services

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ORGANIZATION STRUCTURE Organisational Setup Name of the Bank

UCO BANK

Address of the Bank’s Head 10, BTM Sarani, Kolkata – 700 Office 001 Legal Structure

BANKING COMPANY

Share holding pattern

(% of Equity )

i)

GOI

60.59%

ii)

Public

14.56%

iii)

Others10.46% Organisational Chart of the Bank

Source: UCO Bank website Table I: Organizational Structure (UCO Bank)

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PURPOSE OF STUDY The purpose of the project is to understand how the asset and liability of a bank is managed and to highlight the importance it plays in achieving the Corporate Objective i.e. optimizing the NIM with minimum calculated risk, taking into consideration the business profile of the bank and the regulator’s guidelines.. The study also involves understanding the practices of risk management as per the RBI guidelines and the organizational set up thus developed and the roles and responsibilities of each involved in asset liability management. Further, the objective is to proactively deal with asset liability crisis situations and suggest probable solutions.

SCOPE OF STUDY The study is based on PSU banks and the structural part of it is based on hypothetical data developed based on UCO Bank. Since the data related to the details of asset liability management of a bank is sensitive and beyond public domain, here approximation of the asset liability statement of a PSU Bank is used and the RBI assumptions of bank specific and market specific crisis are loaded on it to study the situations and derive probable solutions.

METHODOLOGY In order to arrive at the findings, essentially the techniques of evaluating the risks involved in asset liability management as per the RBI guidelines are studied. For the present study, the following served as the primary source of information: The Reserve Bank of India guidance note on Asset Liability Management, Asset Liability Management Policy of UCO Bank and Various circulars issued by UCO Bank on the subject. Based on these, hypothetical structural liquidity was developed on which crisis specific scenario assumptions were applied to understand the outcome in stressed condition.

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ASSET LIABILITY MANAGEMENT 2009

P 17

ROJECT DETAILS

SUBARNA GUPTA

ASSET LIABILITY MANAGEMENT 2009

INTRODUCTION 1.1 DEFINITION OF RISK Risks are uncertainties resulting in adverse outcome, adverse in relation to planned objective or expectations. The term, risk is derived from the Latin word rischare meaning ‘to run into danger’. In statistics, risk is often mapped to the probability of some event which is seen as undesirable.

1.2 RELATION BETWEEN RISK & RETURN Corporations operate in a dynamic environment and hence the future remains uncertain to a large extent. With the help of probability theory and careful evaluation of the environment, companies are now able to predict, to some extent, the various risks that may have a critical impact on their business. There are many reasons for business firms to take risks, primary need being profit motivation and maximize shareholder’s wealth. Risk is important to earn reward. Risk in a business or investment is netted against the return from it. There is direct relation between risk and reward. The potential return rises with an increase in risk. Low levels of uncertainty (low risk) are associated with low potential returns, whereas high levels of uncertainty (high risk) are associated with high potential returns. According to the riskreturn tradeoff, invested money can render higher profits only if it is subject to the possibility of being lost. Taking on some risk is the price of achieving returns; therefore, if you want to make money, you can't cut out all risk. The goal instead is to find an appropriate balance. Hence Risk optimization and not risk elimination should be the prime goal of Risk Management.

Figure II: Graph showing risk return trade-off

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RISK IN CONTEXT OF BANKING SECTOR Banks are financial intermediaries. They are confronted with various kinds of financial and non-financial risks viz., credit, interest rate, foreign exchange rate, liquidity, equity price, commodity price, legal, regulatory, reputational, operational, etc. These risks are highly interdependent and events that affect one area of risk can have ramifications for a range of other risk categories. Thus, top management of banks needs to attach considerable importance to improve the ability to identify measure, monitor and control the overall level of risks undertaken. Banking risk management is both a philosophical and operational issue. As a philosophical issue, banking risk management is about attitudes toward risk and the pay off associated with it, and strategies in dealing with them. As an operational issue, risk management is about the identification and classification of banking risks, and methods and procedures to measure, monitor and control them (Angelopoulos and Mourdoukoutas, 2001, p. 11) So far as banking business is concerned, the business lines can be regrouped into 3 categories on the basis of risk associated with them. These are:1. Risk to the banking books: The banking book includes all types of deposits, loans and borrowings on account of all commercial and retail banking transactions. The types of risk associated with such exposures are mainly Credit Risk and Operational Risk and to some extent Market Risk. 2. Risk to the trading books: The trading book includes all marketable assets, i.e. investment in all types of securities, equities, foreign exchange assets. The types of risks associated with such exposures are mainly Market Risk, Credit Risk/Default Risk and Operational Risk. 3. Risk to Off-balance sheet items: The off-balance sheet exposure includes bank guarantees, letter of credits, derivative instruments like futures, options, swaps, forward contracts, etc. These are contingent exposures which can turn out to be fund based exposures and attract all risk associated with the banking books and trading books.

2.1 TYPES OF RISKS Different types of risk inherent in banking and financial services are: 2.1.1 CREDIT RISK: Risk of loss due to a debtor's non-payment of a loan or other line of credit (either the principal or interest (coupon) or both).

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Banks are in the business of taking credit risk as their business is to lend to borrowers with different risk category at a premium than the zero risk rate. There is always a chance that a borrower/counter party may fail to honour his commitment to pay as a result of which the credit risk crystallizes to the bank. The responsibility of managing credit risk lies with the Credit Risk Management Committee. Financial Contracts designed to transfer credit risk on loans and advances, investments and other assets and exposures from one party to another are called Credit Derivatives. The different types of credit risk are: Default Risk- It is the risk of non-recovery of sums due from outsiders, which may arise either due to their inability to pay or unwillingness to do so. Credit Spread Risk or Down grade Risk- It results when rating agencies lower their rating on a bond resulting in decline in the bond prices. Counterparty Risk- It is the inability or unwillingness of a customer or a counter party to meet the commitments in relation to lending/ trading/ hedging/ settlement or any other financial transaction. Country Risk- Those changes in the business environment which adversely affect operating profits or the value of assets in a specific country are referred to as Country Risk. 2.1.2 MARKET RISK: The possibility of loss arising out of any adverse change in the market variables like interest rate, exchange rate, equity price, commodity price etc are called Market Risk. Market risk is more visible in Trading Activities [like debt instruments, equity, foreign exchange, commodity, etc] than in advance portfolio of the banks. At the corporate level the Asset and Liability Management Committee [ALCO] is responsible for the management of the market risk. Market risk is again of the following types: i. Interest rate risk: The possibility of loss due to the change in the interest rate in the market is called Interest Rate Risk. This loss involves both the net interest income to the bank and also the erosion in the value of the securities affecting the net worth of the bank due to more provision/Loss. Interest Rate Risk can be further divided into: a) Gap or Mismatch Risk: b) Basis Risk: c) Embedded Option Risk:

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d) Reinvestment Risk: e) Price Risk: These are explained in details in the following chapters. ii.

Liquidity risk:

The inability to honour the withdrawals and commitments is called Liquidity Risk. It is the risk of cash shortage when it is needed. It arises from maturity mismatch. It involves a) Funding Risk, b) Time Risk and c) Call Risk. These are explained in details in the following chapters. iii.

Foreign exchange risk:

It is the risk that a bank may suffer losses as a result of adverse exchange rate movements during a period in which it has an open position, either spot or forward, or a combination of the two, in an individual foreign currency.

2.1.3. OPERATIONAL RISK: This is defined as The Risk Direct or Indirect Loss resulting from Inadequate or Failed Internal Process, People and System or from External Events. The operational risk can be further divided into the following types: Fraud Risk-. Risks due to any fraud, forgery by internal as well as external sources are referred to as Fraud Risk. Communication Risk- Risk due to any inconvenience caused as a result of miscommunication or misunderstanding is known as Communication Risk. Documentation Risk- It is the probability of loss that a legal agreement may turn out to be incomplete, insufficient, or otherwise unenforceable. Transaction Risk- It is the risk arising from fraud, both internal and external, failed business processes and the inability to maintain business continuity and manage information. Legal Risk- It is the risk that legal systems will expropriate value from shareholders Competence Risk- It is the risk arising from an awareness of one's limitations in both experience and knowledge and a willingness to supplement existing experience and knowledge. Model Risk- A type of risk that occurs when a financial model used to measure a firm's market risks or value transactions does not perform the tasks or capture the risks, it was designed to.

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Technology Risk: The risk of loss due to system failure, system security, programming errors, telecommunication error, absence of disaster recovery plan, computer related frauds, etc is called Technology Risk. Reputation Risk: It is the negative public opinion impacting the depositors and market confidence on the bank and thus the loss of business. Cultural Risk- Cultural risks occur as the result of different expectations, misunderstandings and miscommunications between a buyer and the seller of products/ services. External Events Risk- It comprises of variety of pitfalls that can affect a company’s ability to repay its debt obligations on time. It may be due to poor management, change in management, failure to anticipate shifts in company’s market, rising cost of raw materials, regulations and new competition, etc. Management Risk: The risk of loss due to wrong business decisions, improper implementations of decisions, lack of responsiveness to industry changes is called Management Risk Regulatory Risk- It is the risk that statute or a policy of a regulatory body conflicts with intended transaction Compliance Risk- It is the risk of legal or regulatory sanction, financial loss or reputation loss that a bank may suffer as a result of its failure to comply with any or all of the applicable laws, regulations, code of conduct and standards of good practice. At the corporate level, the Operational Risk Management Committee [ORMC] is responsible for the management of operational risk.

TRANSACTIONS

PARTICIPANTS

RISKS EXPOSED TO

foreign currency loans fixed interest rate loan variable rate loan variable rate loan Short-term loan Equities

foreign investor Domestic borrower (foreign) lender domestic borrower (foreign) lender greater domestic borrower (foreign) investor

Interest rate risk, credit risk exchange rate risk Interest rate risk interest rate risk credit risk refunding or liquidity risk Credit risk; market risk from changes in exchange rate; market price of the stock.

Bonds

(foreign) investor

Credit risk and market investment risk.

Hard currency bonds domestic borrower Table II: Some probable risk scenarios

2 2

Exchange rate risk.

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RISK MANAGEMENT Risk management is the systematic process of identifying the risks the business faces, evaluating them according to the likelihood of their occurrence and the damage that could ensue, deciding whether to bear the risk, avoid the risk, control the risk or insure against the risk [or any combination of these four], allocating responsibility for dealing with them, ensuring that the process actually works, and reporting material problems as quickly as possible to the right level. All financial intermediation entails the assumption, management and pricing of risk.

3.1 KEY FACTORS IN THE EVOLUTION OF FINANCIAL INSTITUTION RISK MANAGEMENT PRACTISE: Several factors have contributed to the increased focus on risk management: Term disintermediation between maturing assets and liabilities. Market volatility. Interest rate volatility. Default possibilities. The deregulation of financial markets. The increasing role of securities and derivative products in financial intermediation. The increase in the risk profiles of organizations, with increased emphasis on activities which require the assumption of risk, deliberately. The volatility of markets and its impact on financial institutions. The pressure from capital market investors for returns related to the relative riskiness of their investments and The regulatory requirements for a framework for the management of risk.

3.2 STEPS INVOLVED IN RISK MANGEMENT Risk management therefore involves three steps: 1) Identification of all types of risks the business can face and thus prepare a Risk Profile. 2) Measurement of these risks. 3) Taking measures to control and monitor risk. Identification of risk: The method of listing risk and grouping them into logical groups is called identification of risk or risk analysis .This leads to the preparation of a risk profile of the organization. The RBI has provided templates for finding out the Risk Profiles of the bank. The Risk profile of the bank has to be constructed and be reviewed at quarterly intervals.

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Measurement of risk: There are different methods of measurement of risk. Some of them are: Uncertainty Analysis, Sensitivity Analysis and Probability Analysis. All these methods are statistical methods and therefore require adequate, reliable unbiased data base. Taking measures to monitor and control risk: The different types of risks can be managed by choosing to bear the risk, avoid the risk, control the risk or insure the risk or a combination of any of these.

3.3 TECHNIQUES OF RISK MANAGEMENT Managing risk is a very important area of concern in Risk Management. These techniques include: (a) Risk avoidance, (b) Risk reduction, (c) Risk maintenance and (d) Risk transfer. It is a priority to decide which technique to use for which risk. The scope of a decision varies in each organization. The extent of potential loss, its probability as well as the cost involved in each of the techniques are the critical factors in deciding the course of action.

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ASSET LIABILITY MANAGEMENT [ALM] & ITS IMPORTANCE IN BANKS 4.1 DEFINITION Asset Liability Management, an important risk management, is defined as the strategic management of assets and liabilities in the balance sheet in such a way that the netearning from interests is maximized and Liquidity Risk and Interest Rate Risk are minimized. It is the process of adjusting bank liabilities to meet loan demands, liquidity needs and safety requirements. It is mandatory now for banks since April 01, 1999. Date

Table III:

4.2

Event

State of ALM

Pre-1960s

Asset Management and Portfolio Matching

1961

Advent of Liability Management

1975

Stagflation

Birth of GAP Analysis

1982

PCs

Advent of Simulations

1984

Value recognition

Duration Analysis

1988

Options proliferation

Prepayments Models

Now

Complexity and Rope

Integrated Risk Management

ALM History

IMPORTAN CE

OF

ASSET

LIABILITY MANAGEME NT

A vital issue in strategic management of Banks’ Balance Sheet, is asset and liability management (ALM), which is the assessment and management of endogenous-financial, operational, business--and exogenous risks. The objective of ALM is to maximize returns through efficient fund allocation given an acceptable risk structure. ALM is a multidimensional process, requiring simultaneous interactions among different dimensions. If the simultaneous nature of ALM is discarded then decreasing risk in one dimension may result in unexpected increases in other risks. ALM has changed significantly in the past two decades with the growth and integration of financial institutions and the emergence of new financial products and services. New information-based activities and financial innovation increased types of endogenous and exogenous risks as well as the correlation between these. Consequently, the structure of balance sheet instruments has become more complex and the volatility in the banking

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system has increased. These developments necessitate the use of quantitative skills to manage risks more objectively and improve performance.

4.3 SIGNIFICANCE OF ALM Significance of ALM lies in addressing the risks arising out of changes in interest rates, exchange rates and credit risk and liquidity position of the bank in the balance sheet of the bank. Reasons for growing significance of ALM are: Term intermediation: Term intermediation between maturity of assets and liabilities exposes the bank to liquidity risk which requires proper management of the assets and liabilities. Volatility: Free economic environment often leads to fluctuations in rates reflected in the interest rate structure, money supply and overall credit position of the market. These affect the market value of the bank and its Net Interest Income. Product Innovation of financial products of the bank imparts effect on the risk profile of the bank. Regulatory Environment: BIS (Bank for International Settlements) provides framework to banks for coping with risk arising out of excessive credit risk and rate fluctuations. Thus, like other Central Banks, RBI in India has provided guidelines to banks to adopt ALM. Management Recognition: All these reasons resulted in serious attitude of management towards relating the asset and liability side of Balance sheet and thus efficient ALM is required. Cross border transaction and seamless integration of domestic and global markets also leads to chances of risk as is found recently in the case of Lehman Brothers which in course of time, affected the global economy as a whole.

4.4 PARAMETERS FOR LIABILITY MANAGEMENT:

STABILIZING

ASSET

Liquidity: Whether the liquidity situation is healthy and under control is the basic parameter to stabilize the asset liability management. Net Interest Income: Interest income – interest expenses. It measures effect of fluctuations in rates on short-term profits. Net Interest Margin: Net interest income divided by average total asset. Higher the spread between total interest income and the total interest expense, higher the net interest income and thus, higher the net interest margin. Economic Equity Ratio: Ratio of shareholders’ funds to the total assets. It measures the shifts in the ratio of owned funds to total funds.

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ALM ORGANIZATIONAL STRUCTURE The Asset Liability Management Committee (ALCO) should function as the top operational unit for managing the balance sheet within the performance/risk parameters laid down by the Board according to the RBI guidelines. Ideally, the organization set up for Market Risk Management should be as under The Board of Directors The Risk Management Committee The Asset-Liability Management Committee (ALCO) The ALM support group/ Market Risk Group

5.1 COMPOSITOPN OF ALCO The CEO/CMD or the ED should head the Committee. The Chiefs of Investment, Credit & Credit Monitoring Finance/Resources Management or Planning, Funds Management / Treasury (forex and domestic), International Banking and Economic Research can be members of the Committee. In addition, the Head of the Technology Division should also be an invitee for building up of MIS and related computerization. Some banks may even have Sub-committees and Support Groups.

5.2 THE MIDDLE OFFICE Ideally Middle office acts as ALCO’s secretariat, reporting directly to ALCO and monitoring abidance of organizational operations to the guidelines and mandate provided by the Board. Banks without formal Middle Offices must ensure that risk control and analysis should rest with a department with clear reporting independence from Treasury or risk taking units, until formal Middle Office frameworks are established. The Middle Office is responsible for the critical functions as follows: independent market risk monitoring, measurement, research, analysis and reporting for the bank's ALCO.

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An effective Middle Office provides the independent risk assessment which is critical to ALCO's key-function of controlling and managing market risks in accordance with the mandate established by the Board/Risk Management Committee. The methodology of analysis and reporting varies from bank to bank depending on their degree of sophistication and exposure to market risks and which may vary from simple gap analysis to Computerized VaR modelling.

5.3 THE DEALING ROOM The Dealing Room acts as the bank's interface to international and domestic financial markets and is responsible for meeting the needs of business units in pricing market risks for application to its products and services. The Dealing Room is responsible for meeting the needs of business units in pricing market risks for application to its products and services.

5.4 THE BACK OFFICE The Back Office is responsible for issuing and receiving confirmations for transactions concluded by the Dealing Room. The various functions of the back office are: The control over confirmations both inward and outward: All confirmations for transactions concluded by the Dealing Room must be issued and received by the Back Office only. Discrepancies in transaction details, non-receipts and receipts of confirmations without application are resolved promptly to avoid instances of unrecorded risk exposure. The control over dealing accounts (vostros and nostros): Prompt reconciliation of all dealing accounts is an essential control to ensure accurate identification of risk exposures. Unreconciled items and discrepancies in these accounts must be kept under heightened management supervision as such discrepancies may at times have significant liquidity impacts, represent unrecognized risk exposures, or at worst represent collusion or fraud. Revaluations and marking-to-market of market risk exposures: All market rates used by the bank for marking risk exposures to market used to revalue assets or for risk analysis models such as Value at Risk analysis, are sourced independently of the Dealing Room to provide an independent risk and performance assessment. If the bank has an established and independent Middle Office function, this responsibility may properly pass to the Middle Office.

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Monitoring and reporting of risk limits and usage: Reporting of usage of risk against limits (such as counterparty limits, overnight limits etc.) established by the Risk Management Committee, maintenance of all limit system and access to limit system are maintained by the Back Office independently of the Dealing Room. Control over payments systems: The procedures and systems for making payments are under at least dual control in the Back Office independent from the dealing function.

5.5 FUNCTIONS OF ALM: ROLES AND RESPONSIBILITIES Management of market risk is among the major concerns of top management of banks. The Boards should clearly articulate market risk management policies, procedures, prudential risk limits, review mechanisms and reporting and auditing systems. The policies should address the bank’s exposure on a consolidated basis and clearly articulate the risk measurement systems that capture all material sources of market risk and assess the effects on the bank. The operating prudential limits and the accountability of the line management should also be clearly defined. Successful implementation of any risk management process emanates from the top management in the bank and its strong commitment to integrate basic operations and strategic decision making with risk management. 1. The Board of Directors should have the overall responsibility for management of risks. The Board should decide the risk management policy of the bank and set limits for liquidity, interest rate, foreign exchange and equity price risks. 2. The ALCO (Asset Liability Committee) should be responsible for ensuring adherence to the limits set by the Board as well as for deciding the business strategy of the bank in line with bank’s budget and decided risk management objectives. The ALCO is a decision-making unit responsible for balance sheet planning from risk-return perspective including strategic management of interest rate and liquidity risks. The role of the ALCO should include, inter alia, the following : product pricing for deposits and advances deciding on desired maturity profile and mix of incremental assets and liabilities articulating interest rate view of the bank and deciding on the future business strategy reviewing and articulating funding policy reviewing economic and political impact on the balance sheet

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ALM PROCESS The ALM process rests on three pillars: o ALM Information Systems Management Information Systems Information availability, accuracy, adequacy and expediency o ALM Organisation Structure and responsibilities Level of top management involvement o ALM Process Risk parameters Risk identification Risk measurement Risk management Risk policies and tolerance levels.

ALM Information System A proper management information system provides accurate and adequate information to the ALM system and this requires extensive computerization of the bank, so that the requisite information becomes readily available. The details of importance and application of IT and software in this regard are discussed in following chapter. . ALM Organization The Board of Directors have the overall responsibility for the ALM & risk management and lay down the tolerance limits for liquidity and interest rate risk in line with the organization’s philosophy. However, the Asset Liability Committee (ALCO) is responsible for deciding on the business strategies consistent with the laid down policies and for operatinalising them. Typically, ALCO consists of the senior management, including the Chief Executive. ALCO is supported by an efficient analytics providing detailed analysis, forecasts, scenario analysis and recommendation for action. ALCO not only makes business decisions, but also monitors their implementation and their impact. Further, it also takes action and initiates changes in response to the market dynamics. ALCO Support Group will provide the data analysis, forecasts and scenario analysis for ALCO. This relevant data, its collection and flow of information for formulation of STL statement as well as for monitoring the overall ALM process and functioning in the bank, the organizational set up functions as follows:

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Board of Directors Risk Management committee ALCO ALM cell Financial planning department Credit analysis department

Credit risk management department

Middle office

Treasury Back Office Front Office

Investment and loan department

Fig II: Flow of information towards decision making in ALM

ALM Process The scope of the ALM function typically covers liquidity risk management, market risk management, funding and capital planning and profit planning & road projection. The RBI has laid down detailed guidelines for asset liability management in 1999. Their focus is mainly on liquidity and interest rates risks. The guidelines specify the use of a maturity ladder upto 8 time buckets and calculation of cumulative surplus or deficit of funds at selected maturity dates is adopted as a standard tool. The formats of statement of structural liquidity are given by the Reserve Bank of India. Detailed guidance also is given for the classification of the assets & liabilities in each time bucket provided in annexure II. Guidelines also provide a format for estimating short-term dynamic liquidity in a time horizon spanning one day to six months. This tool is to be used for estimating short-term liquidity profiles on the basis of business projections and other commitments. The gap i.e., the difference between rate sensitive assets and rate sensitive liabilities is to be used as a measure of interest rate sensitivity. The guidelines also provide benchmarks about the classification of various components of assets and liabilities into different time buckets for preparation of GAP reports. However, the bank needs to estimate the future behavior of assets and liabilities and off--balance sheet items in response to changes in market variables and also the probabilities of options on internal transfer pricing model for assigning values for funds sourced and funds used for operating their ALM system. In fact, such estimates provide a rational framework for pricing of assets and liabilities.

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Risk Measurement and Board Reporting: Risk Measurement The following are minimum risk and performance measures of ALM, required by sound business and financial practices: • Periodic measurement of overall balance sheet mix. • Periodic measurement of asset, liability and capital growth or decline. • Periodic measurement of operational cash flows. • Periodic measurement of financial margin. • Periodic measurement or projection of the impact of interest movements. • Periodic measurement of the level of unhedged foreign currency funds. • Periodic assessment of the appropriateness of financial derivatives held. The credit union must also meet ALM measurement requirements set out in the Act and Regulations. The credit union may track any other measures of the loan portfolio as it sees fit. These measurements are compared to financial targets in the annual business plan and the budget and the management determines whether the bank is meeting its goals. Management can also assess whether there are material variances from the plan which need to be addressed. Comparison of these measurements against historical performance, where possible, also identifies significant trends which may need to be addressed by management. Variances from the business plan in the volume and mix of loans, investments and deposits, are also measured and monitored as this could have serious effects on net financial margin. Different types of loan and investment categories will provide different yields. Measurement of the portfolio mix can alert management to future declining margins caused by an unfavourable shift towards lower yielding loans. Conversely, higher than expected asset yields could reflect an undesired shift toward higher risk loans and investments. Written explanations for changes in mix and yields should be provided by management to the board for its periodic review of the financial statements. The average costs of other sources of funding (borrowings and equity) should be monitored at least quarterly by board and management to determine if they are reasonable. Where interest/dividends are paid to members at the end of the year, these should be estimated and accrued for interim reporting. Structural Liquidity Risk Liquidity risk is the inability to meet commitments more pronounced in the short term. Maturity Profiles of inflows and outflows which are mostly not matched cause structural liquidity problems. Structural Liquidity risk is measured in multiple ways. A realistic measure is an absolute value of gap between inflows and outflows by maturity bucket.. Interest Rate Risk Gap between interest rate sensitive assets and liabilities, spread over time is a measurement of market risk. This measure is a basic measurement technique. Sensitivity of Net Interest Income (NII) to interest rate change is another way of measuring the interest rate risk. The Basel Committee on Bank Supervision stipulates

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the benchmark in this regard as the 200 basis points parallel shift in yield curve. However, central banks of individual countries have the freedom to vary this norm.

Inadequacy of balance sheet analysis for ALM ALM techniques are used over and above balance sheet techniques. First of all, ALM takes into account the time value of money whereas balance sheet accounting ignores time element. Secondly, ALM requires factoring the off-balance sheet items to estimate their potential impact on the banks e.g., unutilized portion of cash credit. Further, the ALM involves holistic perspective for decision-making and factors in the market dynamics. Mapping Non-term products Certain products like savings bank have no contracted maturity terms. Therefore, there is conceptual difficulty in mapping them into zero coupon bonds as the timing of the occurrence of such cash flows is not known. They are generally split into two or more parts based on their behaviour. These parts are volatile and core. Core is expected to be with the bank and will report in later time buckets. Volatile portion is typically assigned to the first bucket. Probabilistic cash flow products Savings bank and current account are examples form the banking book of probabilistic cash flow behaviour. Probability is deliberate in derivative class of instruments. Thus, complex and sophisticated models are required to map derivative type of instruments into the cash flow model. Options, Futures and derivatives Bank uses these instruments to hedge positions. To offer a customer a long position in Rupees at a certain rate, bank has to hedge by taking a corresponding short position. Thus, regardless of Rupees rate changes, bank is fully protected, offering customer protection as well. Options, futures and derivatives may be used to take positions, apart from hedging. Basel II norms specify different treatments for the derivatives. Transfer Pricing for Measuring Profitability Profitability by business units, as given out by simple balance sheet is distorted. A business unit or a branch located in a residential area is by definition a deposit-taking branch. Thus, its profitability should be measured by efficiency of deposit collection i.e., weighted average interest rates of deposit collection by time buckets compared to a standard yield curve. Thus, concept of funds transfer pricing has emerged strongly in the past few years. Strategising ALM Framework ALM policy is drafted and updated by bank’s ALCO. ALM policy requires that board of directors, Asset Liability committee follow a formal procedure. ALM Policy covers bank’s position on all risks – credit risk, market risk, liquidity risk etc. Banking keeps changing

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and in times will change even further. Thus, ALM policies need to change with the changes in the market on a continuous basis. This ensures that practices are current, though business itself does not change. In India, for example, for a large number of years, it was liability creation that was the prime driver. Once bank gathered enough funds, the banks would look at multiple asset creation avenues. However, of late, it is the asset creation that drives the liability growth.

Product Both assets and liabilities are considered products and operational parameters defined for both. For example, deposits may have various characteristics and structures for interest rates. Competition may introduce new products based on their ALM positions. The policy defines products that the bank may deal in – both on assets and liabilities. Complexities are introduced by options – both explicit and embedded. Savings bank and cash credit is a classic case of embedded options. Thus, ALCO needs to understand impact of probabilistic cash flows before approving such products. Before being offered, product creation needs to go through a proper introduction and approval mechanisms through Risk Management and ALCO. Thus, policy should address parameters that should never be crossed. Structural Liquidity Structural liquidity is critical for an institution. Therefore, policies are laid out for measurement and implementation of liquidity controls in any financial institution. Individuals practice structural liquidity measurement and control for personal portfolios. Hence, these are even more vital for a financial organization. Gap Measurement Time buckets are defined as a maturity bucket scheme. All cash flows are mapped to corresponding buckets. Thus, entire portfolio of cash flows is now reduced to a bucket representation, thus making it easier to analyse. Since all products are mapped, assets represent all inflows and liabilities represent all outflows. Thus gaps in each time bucket are analysed. Regulators specify use of percentage of tolerance for gaps. Practical bankers use an absolute amount. Thus, as long as gap remains within tolerance, it is within known manageable limits. There cannot be zero gap in ideal situation. Cost to close gap This is another measurement for structural liquidity. The last bucket is closed first using market interest rate for that bucket. Some implementations divide all buckets to months internally and calculate cost to close at month level. Cost to close of the last bucket is them taken as an outflow in the previous bucket and that closed and so on all the way till the first bucket is closed. That gives the total cost to close gap. The other way is to simply calculate cost to close gap for each bucket based on interest rate and assuming that all cash flows occur at the gap median.

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Tolerance to limits of cost to close is defined as a measure of structural liquidity risk and this is used for control.

Scenario Analysis Liquidity analysis scenarios are generated. A typical measure would involve worst case, best case and likely. These scenarios are scrutinized and their impact approved by ALCO as a matter of routine. All analysis referred to above provide measures enabled by these scenarios. Many banks, as a matter of routine, create scenarios on top of native cash flows. They alter nature of native cash flows based on their prior knowledge. Derived cash flows are indeed scenarios that have been pre-defined. Interest rate risk Interest rate risk is measured using traditional techniques for measurement of market risk. Market risk exists due to volatility of interest rates. Financial institutions make money as they take market risk. Interest rate Gap Interest rate gap of a bucket is calculated in a manner similar to liquidity gap. Tolerance of gap in terms of percentage, absolute values is a risk control measure. Tolerance provides control point as well. NII Sensitivity analysis Sensitivity of Net Interest Income to movement in interest rates may be determined by assuming a change in the interest on assets/liabilities. It is assumed that 100% of assets and liabilities will get re-priced. This may not be realistic and re-pricing % is a parameter that must be determined by bank’s behaviour. Thus, sensitivity of NII to interest rate movement and interest rate shocks are a interest rate risk measure that may be used. Unlike duration, this is more simplistic and will not carry the concept of ‘time value of money’. Scenario Analysis Interest rate sensitivity analysis scenarios are generated. A typical measure would involve worst case drop in NII - rate shock of x% on cost and y% on yield, best case and likely. These scenarios are scrutinized and their impact approved by ALCO as a matter of routine. All analysis referred to above may be measured for above scenarios. Many banks, as a matter of routine, create scenarios on top of native cash flows. They alter nature of native cash flows based on their prior knowledge. Derived cash flows are, indeed, scenarios that have been pre-defined. Implementation Issues: 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 address all issues concerning the bank and

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are clearly explained to all members of board, apart from ALCO and these are documented. Proper revisions to this document, a quarterly review needs are organized as well as parameters may be changing due to change in situations.

Organization and culture ALM function needs to be separated clearly from operations as it involves control and strategy functions. Risk organization in banks generally land up reporting to treasury, as they are people who come closest to understanding complex financial instruments. The fact that they are a business unit, in charge of ‘risk taking’ is overlooked. ‘Risk Taking’ and ‘Risk management’ are generally two distinct parts of any organization and both must report to a board completely independently. Openness and transparency are essential to a proper risk organization. Most organizations react badly to some positions going wrong by taking more risks and enter vicious cycle of risks. Thus, it is required to follow policy implicitly in both letter and spirit. Most dramatic failures in the last decade have not been because of market risk or credit risk but bad risk management organizations. This must be a big pointer to boards and ALCOs on avoidance of such issues. Data and models Data is not available at all times in requisite format. Many data items are assumptions as for e.g. the case of a manual branch of a bank that was closed for some period in a year due to riot/strike/bandhs/natural diaster completely destroying the data base. As data may not be obtained from this branch for some period still data is recovered /restored, appropriate assumptions has to be made. The argument is that for all other purposes, assumptions are being made. Risk Management: Corrective Action An important activity in the effective management of risk is management's timely response to unauthorized risk or poor performance developments. As a follow up to the asset/liability risk measurements taken by the bank, management should investigate all significant performance variances relative to the annual business plan and to historical performance, and respond by taking action to correct these variances. Management must similarly respond to any contravention of board policy or regulatory requirements, or other unauthorized risk. Operational Procedures Procedures can assist management in ensuring regulatory and policy requirements are met with respect to asset/liability mix, interest rate risk exposure, foreign exchange rate exposure, and derivatives use. To assist in implementation, procedures should be both appropriate and cost effective given the size of the credit union's operations. It is a sound business and financial practice for credit unions to document procedures. Written procedures result in higher staff productivity and better control over resources.

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MANAGEMENT OF LIQUIDITY RISK

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Bank’s liquidity management is the process of generating funds to meet contractual or relationship obligations at reasonable prices at all times. Measuring and managing liquidity needs are vital activities of commercial banks. By assuring a bank’s ability to meet its liabilities as they become due, Liquidity Management can reduce the probability of developing adverse situations. Banks normally keep their liquid funds in Cash and Balance with RBI, Balance with other banks. Money at Call and Short Notice and in Investments. To meet the liquidity gap, banks adjust their surplus / deficit by investing the surplus funds in short / long term securities and by disinvesting securities or by borrowing funds from the market to meet the shortfall. OUTFLOWS

INFLOWS

Capital

Cash

Reserve and surplus

Balances with RBI

Deposits

Balances with other banks

Borrowings

Investments

Other liabilities and provisions

Advances(performing)

Lines of credit committed

NPAs(Advances and Investments)

Unavailed portion of cash credit / overdraft

Fixed assets

Letters of credit / guarantees

Other assets

Repos

Reverse Repos

Bills rediscounted

Bills rediscounted

Swaps

Interest receivable

Interest payable

Committed lines of credit

Others

Export refinance from RBI Others

Table IV: Composition of Liquid Fund

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7.1 ADEQUACY OF LIQUIDITY POSITION FOR A BANK A bank’s adequacy of liquidity position can be determined by analyzing the following factors: a. 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 Proper analysis of these factors leads to effective liquidity management which helps the bank to Maintain credibility in the market Meet its formal and informal prior loan commitments Avoid unprofitable sale of assets Lower the size of default risk premium to be paid for funds

7.2 SOURCES OF LIQUIDITY RISK Liquidity Exposure can stem from both internally and externally. •

External liquidity risk can be geographic, systemic or instrument specific.



Internal liquidity risk relates largely to perceptions of an institution in its various markets: local, regional, national or international

7.3 TYPES OF LIQUIDITY RISK •

Funding Risk: It arises from the need to replace net outflows due to unanticipated withdrawals/non-renewal of deposits; the respective sources can be: o Fraud causing substantial loss o Systematic Risk o Loss of confidence o Liability in foreign currencies



Time Risk: It arises from the need to compensate for non-receipt of expected inflows of funds; it can stem from: o

Severe deterioration in the asset quality

o Standard assets turning into non-performing assets o Temporary problems in recovery

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o •

Time involved in managing liquidity

Call Risk: It arises from crystallization of contingent liability; the sources can be: o

Conversion of non-fund based limit into fund-based

o

Swaps and options

7.4

MEASURING AND MANAGING LIQUIDITY RISK

This can be done through the following 2 approaches: 1. Stock Approach 2. Cash Flow Approach

7.4.1 Stock Approach This is based on the level of assets and liabilities as well as off balance sheet exposures on a particular date. The following ratios are calculated to assess the liquidity position i) Ratio of core deposit to total assets- Higher value of ratio is appreciated as core deposits (deposits from the public) are stable source of liquidity. ii) Net loans to total deposits ratio-Lower the ratio, the better since loan is treated to be less liquid asset and here net loan means net advances after deduction of provision for loan losses and interest suspense account.

iii) Ratio of time deposits to total deposits-Time deposits () provide stable level of liquidity and less volatility. So, higher the ratio the better it is. iv) Ratio of volatile liabilities to total assets –high proportion of volatile assets cause higher liquidity problem and as a result lower the ratio the better it is.

v) Ratio of short-term liabilities to liquid assets – Short term liability requires ready liquid assets to meet the liability. Hence the ratio is expected to be lower. vi) Ratio of liquid assets to total assets- As higher level of liquid assets ensure better liquidity, So higher ratio is expected. vii) Ratio of short-term liabilities to total assets- A lower ratio is desirable since short-term liabilities include balances in current account, volatile portion of savings.

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viii)Ratio of prime asset to total asset- Prime asset includes cash balances or balances with banks or RBI which can be withdrawn at any time without notice. Hence higher ratio is desirable.

ix) Ratio of market liabilities to total assets- Lower ratio is preferred as market liabilities include money market borrowings; inter bank liabilities repayable within a short period.

7.4.2 Cash Flow Approach While the liquidity ratios are the ideal indicator of liquidity of banks operating in developed financial markets, the ratios do not reveal the intrinsic liquidity profile of Indian banks which are operating generally in an illiquid market. Experiences show that assets commonly considered as liquid like Government securities, other money market instruments, etc. have limited liquidity as the market and players are unidirectional. Thus, analysis of liquidity involves tracking of cash flow mismatches. For measuring and managing net funding requirements, the use of maturity ladder and calculation of cumulative surplus or deficit of funds at selected maturity dates is recommended as a standard tool. The format prescribed by RBI in this regard under ALM System is adopted for measuring cash flow mismatches at different time bands. The cash flows should be placed in different time bands based on future behavior of assets, liabilities and off-balance sheet items i.e. banks should have to analyze the behavioral maturity profile of various components of on / off-balance sheet items on the basis of assumptions and trend analysis supported by time series analysis. The difference between cash inflows and outflows in each time period, the excess or deficit of funds becomes a starting point for a measure of a bank’s future liquidity surplus or deficit, at a series of points of time. The banks should also consider putting in place certain prudential limits to avoid liquidity crisis: 1. Cap on inter-bank borrowings, especially call borrowings 2. Purchased funds vis-à-vis liquid assets; 3. Core deposits vis-à-vis Core Assets i.e. Cash Reserve Ratio, Liquidity Reserve Ratio and Loans; 4. Duration of liabilities and investment portfolio; 5. Maximum Cumulative Outflows: Banks should fix cumulative mismatches across all time bands; 6. Commitment Ratio – tracking the total commitments given to corporate/banks and other financial institutions to limit the off-balance sheet exposure; 7. Swapped Funds Ratio, i.e. extent of Indian Rupees raised out of foreign currency sources.

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The analysis of net funding requirements involves the construction of a maturity ladder i.e. comparison of future cash inflows to outflows over a series of specified time periods.

Whether a bank has sufficient liquidity also depends on the cash flow behavior under alternative scenarios like, a) General market conditions (going concern scenario), b) Bank specific crisis, c) General market crisis. ll. Managing market access i.e. building strong relationships with individual as well as organizational funding sources has direct contribution to enhancing a bank’s liquidity. lll. Contingency planning Banks should prepare Contingency Plans to measure their ability to withstand bank-specific or market crisis scenario. The blue-print for asset sales, market access, capacity to restructure the maturity and composition of assets and liabilities should be clearly documented and alternative options of funding in the event of bank’s failure to raise liquidity from existing source/s could be clearly articulated. Availability of back-up liquidity support in the form of committed lines of credit, reciprocal arrangements, liquidity support from other external sources, liquidity of assets, etc. should also be clearly established.

7.5 CASE STUDY ON DYNAMIC LIQUIDITY: For a better understanding of Dynamic Liquidity analysis, let us take a hypothetical case study of ABC Bank as under: ABC Bank has its books loans and advances of Rs 25000 crores as on 31-12-2007. During the last two years it has achieved growth in advances to the extent of 10% and 11% respectively. The Bank has now sanctioned high value loans to the extent of Rs 250 crores disbursement of which is expected to take place in next 90 days. Based on the past trend and thrust for the new business, the bank is hopeful to achieve net increase in loans to the extent of Rs 1050 crores in the next 90 days. However, loan repayments are estimated at Rs 100 crores during the period. ABC Bank has got deposits of Rs 45000 crores as on 31-12-2007. About 45% of these deposits are payable on demand. Growth in deposits during the past two years was around 8%. The Bank expects some of the large deposits amounting to around Rs 250 crores falling due in the next two months not to be rolled over because of better avenues available to these depositors. The Bank on a conservative basis expects deposit growth to be around 6% in view of past trend and stiff competition from some of the private banks, which have got technological superiority. Based on a budgetary review on growth of deposits, the bank expects growth in deposits of around Rs 650 crores in next 3 months. After taking into account CRR requirements of 4.74% required at present to be

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maintained with RBI, net increase in deposits available for deployment is about Rs 619 crores. ABC Bank desires to participate in bidding of Government securities to the minimum amount of Rs 400 crores in view of better yield considerations compared with available securities and also considering that these securities have only sovereign risk. Redemptions of existing investments falling due in next three months are Rs 125 crores. The net increase in investments is thus estimated at around Rs 275 crores. Bank has cash and balances lying with RBI and other banks to the extent of Rs 50 crores which can be withdrawn immediately. Bank has undrawn export refinance facility of Rs60 crores available with RBI. For the purpose of simplicity, we may measure that there are no major changes in cash flow on account of other assets, other liquidities and off-balance sheet items. The data furnished above result in Dynamic liquidity analysis as follows: (Amount Rupees in Crores) OUTFLOWS

1-90 Days

Net increase in loans and advances

950

Net increase in investments (Treasury bills, Dated Government securities, bonds, debentures, shares, mutual funds)

275

Total Outflows

1225

INFLOWS Net Cash Gain

50

Net increase in Deposits (less CRR obligations)

619

Refinance eligibility (export credit)

60

Total Inflows

729

Mismatch (Inflows –Outflows)

(-) 496

Mismatch as % of total outflows

(-) 40.48%

Table V: Dynamic Liquidity Structure of ABC bank From the given data and analysis, it could be concluded as under: Dynamic liquidity analysis shoes negative mismatch of Rs 496 crores in next 90 days period. The negative mismatch is 40.48% of outflows and is considered at a high level-necessitating bank to look for alternative sources to bridge the gap and overcome the liquidity strain.

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While the Bank has acted aggressively in growth of loan portfolio and wishes to take advantage of investment opportunities, deposit growth is not sufficient to fund asset growth. In a situation like this, when the bank would like to take on the available business opportunities from profitable considerations, it is likely to face liquidity problem unless adequate funds are tied up. One option available with the Bank is to resort to borrowing which will have cost implications. Borrowing of this magnitude can be resorted only if the management is reasonably assured that liquidity problem is of temporary nature and there is a basis to expect substantial accretion in the near future. As the bank has witnessed a slow down in deposit growth in the last two years presumably under the competition of other technology savvy banks, in needs to examine its capabilities to ensure adequate growth in deposits. Various strategies need to be charted out foe accretion of deposits. If the Bank feels that the growth in deposits be modest in coming years, it needs to put certain restrictions on growth of loan portfolio before it is caught in a liquidity problem. The data and analysis carried over in the Dynamic Liquidity Model help bank management to ponder over various issues regarding how to position balance sheet of the bank with the view to capture all business opportunities while at the same time remaining liquid. Dynamic liquidity analysis will be a useful tool provided adequate data is collected on future business trends of major clientele, economic environment of the area in which the bank is predominantly operating and level of competition.

7.6 STRUCTURAL LIQUIDITY STATEMENT (STL): It is the statement produced under the guidelines of RBI showing the various items of inflow and outflow as well as their variations in the various maturity buckets. Following the RBI guidelines the items are placed in various maturity buckets and the gaps and cumulative gaps are calculated to find out whether they remain within the prudential limits prescribed by RBI. Deviations from the prudential limits need to be monitored to avoid adverse effects of various risks. It has to be provided by Indian banks to the RBI on a fortnightly basis. The STL statement as per the guidelines of RBI is provided in annexure I.

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M

ANAGEMENT OF INTEREST

RATE RISK

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Interest rate risk means changes in the interest income due to changes in the rate of interest which will ultimately affect the value of bank’s assets, liabilities and offbalance sheet instruments. A fall in interest rate may adversely affect the interest income from advances. But deposits will have to be carried at higher cost till their maturity if they have already been mobilized for long-term tenure on fixed interest basis. Let us try to understand the effect of interest rate risk from the point of view of a common man, Mr. A considering his following assets and liabilities: Particulars Rate of Interest Assets Savings Bank A/c 3.5% 5 yrs Fixed Deposit 9.5% 5 yrs NSE 9% Current A/c 0% Liabilities Housing Loan-15 yrs(repayable) 12.5% Vehicle Loan-7 yrs 9% Consumer Loan-4 yrs 13.5% Now let us assume that due to ------ the housing loan rate increased by 2% to 14.5%, the vehicle loan rate increased by 2.5% to 11.5% the consumer loan rate increased by 3% to 16.5% So, we can find that as the interest rate of liabilities has increased, the assets of Mr. A cannot match the liabilities in the changed scenario. So he will have to manage his assets in such a way so that he can deal with this problem of mismatch. The scenario is just the opposite in case of banks whose assets are the loans, advances while the savings A/c and current A/c etc. are the liabilities. So the mentioned changes in interest rates will produce completely opposite results for the banks.

Table VI: Expected Balance Sheet for Hypothetical Bank (Rs in crores) Assets Yield Liabilities Rate sensitive 500 8.0% 600 Fixed Rate 350 11.0% 220 Non earning 150 100 920 Equity 80 Total 1000 1000

Cost 4.0% 6.0%

NII = (0.08*500 + 0.11*350) - (0.04*600 + 0.06*220) = Rs.78.5 cr – Rs. 37.2 cr = Rs. 41.30 cr NIM = 41.3/850 = 4.86% GAP = 500 – 600 =-100

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Table VII: 1% Increase in Short-Term Rates: Expected Balance Sheet for Hypothetical Bank

Rate sensitive Fixed Rate Non earning

Assets 500 350 150

Equity Total

1000

Yield 9.0% 11.0%

Liabilities 600 220 100 920 80 1000

Cost 5.0% 6.0%

NII = (0.09*500 + 0.11*350) - (0.05*600 + 0.06*220) = 83.5 – 43.2 = 40.3% NIM = 40.3/850 = 4.74% GAP = 500 – 600 =-100

Table VIII: 1% Decrease in Short-Term Rates: Expected Balance Sheet for Hypothetical Bank

Rate sensitive Fixed Rate Non earning Equity Total

Assets 500 350 150

Yield 8.5% 11.0%

1000

Liabilities 600 220 100 920 80 1000

Cost 5.5% 6.0%

NII = (0.085*500 + 0.11*350) - (0.055*600 + 0.06*220) = 81– 46.2 = 34.8% NIM = 34.8/850 = 4.09% GAP = 500 – 600 =-100

Table IX: Proportionate Doubling in Size: Expected Balance Sheet for Hypothetical Bank

Rate sensitive Fixed Rate Non earning Equity Total

4 7

Assets 1000 700 300

2000

Yield 8.0% 11.0%

Liabilities 1200 440 200 1840 160 2000

Cost 4.0% 6.0%

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NII = (0.08*1000 + 0.11*700) - (0.04*1200 + 0.06*440) = 157– 74.4 = 82.6% NIM = 82.6/1700 = 4.86% GAP = 1000 – 1200 =-200

Table X: Increase in RSAs and Decrease in RSLs: Expected Balance Sheet for Hypothetical Bank

Rate sensitive Fixed Rate Non earning Equity Total

Assets 540 310 150

Yield 8.0% 11.0%

1000

Liabilities 560 260 80 900 100 1000

Cost 4.0% 6.0%

NII = (0.08*540 + 0.11*310) - (0.04*560 + 0.06*260) = 77.3– 38 = 39.3% NIM = 39.3/850 = 4.62% GAP = 540 – 560 =-20 8.1 TYPES OF INTEREST RATE RISK

8.1.1 Mis-match Risk: It is the risk arising from the mismatch in the “repricing maturities” of interest rate sensitive assets and liabilities. For e.g. a deposit contracted for a five year term repricable every six months has a repricing maturity of six months. Such items of assets and liabilities which will be priced / repriced based on the interest rates prevailing at the time of issue / repricing are called “interest rate sensitive assets / liabilities”.e.g. deposits, borrowings, loans, investments etc. On the other hand, premises, computers, stationery etc. are non-sensitive to changes in interest rates in the market. Gap between the interest sensitive liabilities and assets on any day or during a specified time bucket is the measure of the mis-match risk on that day or the time period as the case may be. If more interest rate sensitive assets reprice / mature on a day on a day or over a time interval (time bucket) than interest rate sensitive liabilities during the same period, the gap is called a “Positive Gap” and if more liabilities reprice than assets during the period such gaps are called “Negative Gap”. The following statement illustrates this concept:

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2009

(Rs in crores)

Assets/Liability items

Assets Cash Deposits with banks Investments Loans Premises Total Liabilities & net worth Current Deposits Savings Deposits Term Deposits Borrowings Other Liabilities Net worth Total Interest rate sensitive gap (repricable assets – repricable liabilities)

1-28 days

20 180 1200

29 days 3mnths

100 300

1400

400

600 800 100 400

200 100 300 200

1900 -500

800 -400

>3mnths6mnths

80 320 400

>6mnths1yr

100 400 500

>1yr

Nonsensitive

Totals

20

20 20 960 2820 600 4420

500 600 1100

600 620

20 500

500 -100

200

200

200 +300

100 700 820 +900 -200

820 900 1300 700 700 4420

Cumulative gap -500 -900 -1000 -700 +200 Table XI: Mis-match Risk arising from the mismatch in the “repricing maturities” of interest rate sensitive assets and liabilities. The impact of changing interest rates on the repricing assets and liabilities and in turn the, the combined impact on NII can be analyzed from the above statement. For instance, during the first time bucket liabilities to the extent of Rs 500 cr are repricing over and above the assets repricing during the bucket. The downside for the bank’s NII is that if interest rates rise during the period bank’s NII will be squeezed, as liabilities to the tune of Rs 500 crore will reprice at higher interest rates for the remaining period of the performance horizon of 1 year. Again, in the fourth time bucket assets to the tune of Rs 300 cr reprice in excess of liabilities which reprice during the same time bucket. Here bank’s NII will be adversely impacted if there is going to be a fall in interest rate during the time of pricing. Thus, the relationship between interest rate changes and their impact on net interest income is as follows:

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Gap Interest Rate Change Impact on NII Positive* Increases Positive Positive Decreases Negative Negative Increases Negative Negative Decreases Positive *Note: RSA-Rate Sensitive Assets & RSL-Rate Sensitive Liabilities. Positive Gap is where RSA is more than RSL and Negative Gap is vice versa. Table XII: Relation between Gap, Interest rate change and Impact in NII

8.1.2 Basis Risk: is the risk arising from the differing impact of a given change in any of the bench mark interest rates on the interest rates in various segments such as treasury bills, call money, repo etc.In other words, the risk of change in interest rate of an asset and the corresponding liability in different magnitude is called Basis Risk. Let us take the following e.g. XYZ Bank Ltd. Liabilities

Assets

Call Money Repo Deposits Total

50 Treasury Bills 50 Advances 100 200 Total

150

Negative gap

50

30 120

Table XIIIa: Interest sensitive gap position 1- 30 days bucket If interest rate increases by 1%, bank will lose 0.5 crore per year assuming that the rise in interest will be uniformly applicable to all the items of assets and liabilities. But in real world the interest rates on assets and liabilities do not change in the same proportions. For instance, call may go up by 1%, Repo by 0.5%, deposits by 0.25%, treasury bills by 1.0%and advances by 0.75%. Call Repo Deposits

50 50 100

0.01 0.005 0.0025

Treasury Bills Advances

30 120

0.01 0.0075

Net impact on NII Table XIIb: Net Impact on NII under changed scenario

50

0.5 0.25 0.25 1 0.3 0.9 1.2 0.2

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8.1.3 Yield curve risk: On account of volatility in interest rates, the yield curve unpredictably and often substantially, changes in shape. If the interest rates on assets and liabilities are pegged to the bench mark rates (like treasury bills cut-off rates), there is the risk that the interest spread may decrease as term spread narrows down. Let us assume that a bank has raised a floating rate deposit which will be repriced 1% above the 91 days Treasury Bills (TB) cut-off and invested the amount in a floating rate loan of the same repricing interval but at a spread of 2% above 364 days Treasury Bills cut-off. The following table shows the Yield Curve Risk involved, as the spread between the two maturities of Treasury Bills narrowed. Period

91 days TB

364 days TB

Term Spread

Interest spread between deposits and loans

April 2008

8.75%

10.07%

1.32%

2.32%

June 2008

9.24%

10.32%

1.08%

2.08%

August 2008

9.46%

10.28%

.82%

1.82%

March 2009

9.16%

9.93%

0.77%

1.77%

Table XIV: Yield curve risk involved as the spread between two maturities of Treasury Bills narrowed 8.1.3. Embedded option risk: When a liability or asset is contracted with a call option for the customer, it involves an embedded option risk. Banks provide an option to depositors to prematurely close the deposits and to borrowers to prepay the advances. Now depositors may prematurely close the deposits when interest rate increase and redeposit at higher rates and when interest rates decline borrowers may opt to prepay the loans and renew the same at lower rate. In both the cases bank’s NII is adversely affected.

8.1.4. Reinvestment risk: When a bank gets back the repayment of a loan before the payment of the corresponding liability is due for payment, the rate at which such cash flow can be invested is uncertain and such risk is called Reinvestment Risk. 8.1.5. Price Risk: The decline in the market price of a security due to rise in the market interest rate is called the Price Risk. The values of investments change inversely to interest rates. Thus if interest rates in the market increase, investments suffer depreciation and if interest rates decline

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investments in the bank’s portfolio gain in value. The price changes in investments are on account of the present values of cash flows in the bond being altered when discounted by the new interest rate.

8.2 EFFECTS OF INTEREST RATE RISK Changes in interest rates can have adverse effects both on a bank's earnings and its economic value. This has given rise to two separate, but complementary, perspectives for assessing a bank's interest rate risk exposure. 8.2.1 Earnings perspective: In the earnings perspective, the focus of analysis is the impact of changes in interest rates on accrual or reported earnings. This is the traditional approach to interest rate risk assessment taken by many banks. Variation in earnings is an important focal point for interest rate risk analysis because reduced earnings or outright losses can threaten the financial stability of an institution by undermining its capital adequacy and by reducing market confidence.

. 8.2.2 Economic value perspective : Variation in market interest rates can also affect the economic value of a bank's assets, liabilities and off balance sheet positions. Thus, the sensitivity of a bank's economic value to fluctuations in interest rates is a particularly important consideration of shareholders, management and supervisors alike. The economic value of an instrument represents an assessment of the present value of its expected net cash flows, discounted to reflect market rates.

8.3

INTEREST RATE RISK MANAGEMENT TECHNIQUES

8.3.1 Repricing Schedule: This method distributes interest-sensitive assets, liabilities and off balance sheet positions into a certain number of predefined time bands according to their maturity (if fixed rate) or time remaining to their next repricing (if floating rate). Those assets and liabilities lacking definitive repricing intervals (e.g. sight deposits or savings accounts) or actual maturities that could vary from contractual maturities (e.g. mortgages with an option for early repayment) are assigned to repricing time bands according to the judgment and past experience of the bank. 8.3.2 Gap Analysis: In Gap Analysis process, to evaluate earnings exposure, interest rate sensitive liabilities in each time band are subtracted from the corresponding interest rate sensitive assets to produce a repricing "gap" for that time band. This gap can then be multiplied by an assumed change in interest rates to yield an approximation of the change in net interest income that would result from such an interest rate movement. The size of the interest rate movement used in the analysis can be based on a variety of

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factors, including historical experience, simulation of potential future interest rate movements and the judgment of bank management. 8.3.3 Duration: Duration is a measure of the percent change in the economic value of a position that will occur given a small change in the level of interest rates. It reflects the timing and size of cash flows that occur before the instrument's contractual maturity. Generally, the longer the maturity or next repricing date of the instrument and the smaller the payments that occur before maturity (e.g. coupon payments).

8.3.4. Simulation Approaches: Simulation techniques typically involve detailed assessments of the potential effects of changes in interest rates on earnings and economic value by simulating the future path of interest rates and their impact on cash flows. Simulations can be static or dynamic. In static simulations, the cash flows arising solely from the bank's current on- and offbalance sheet positions are assessed. For assessing the exposure of earnings, simulations estimating the cash flows and resulting earnings streams over a specific period are conducted based on one or more assumed interest rate scenarios. Typically, although not always, these simulations entail relatively straightforward shifts or tilts of the yield curve or changes of spreads between different interest rates. When the resulting cash flows are simulated over the entire expected lives of the bank's holdings and discounted back to their present values, an estimate of the change in the bank's economic value can be calculated. In a dynamic simulation approach, the simulation builds in more detailed assumptions about the future course of interest rates and the expected changes in a bank's business activity over that time. Such simulations use these assumptions about future activities and reinvestment strategies to project expected cash flows and estimate dynamic earnings and economic value outcomes. These techniques allow for dynamic interaction of payments stream and interest rates, and better capture the effect of embedded or explicit option.

8.4 SOUND INTEREST RATE RISK MANAGEMENT PRACTISES Sound interest rate risk management involves the application of four basic elements in the management of assets, liabilities and off-balance-sheet instruments: Appropriate board and senior management oversight; Adequate risk management policies and procedures; Appropriate risk measurement, monitoring and control functions; and Comprehensive internal controls and independent audits.

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M 54

ANAGEMENT RATE RISK OF FOREIGN EXCHANGE

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The risk inherent in running open foreign exchange positions have been heightened in recent years by the pronounced volatility in forex rates, thereby adding a new dimension to the risk profile of banks’ balance sheets. Foreign exchange rate risk is the risk that a bank may suffer losses as a result of adverse exchange rate movements during a period in which it has an open position, either spot or forward, or a combination of the two, in an individual foreign currency. In the forex business, banks also face the risk of default of the counterparties or settlement risk. While such type of risk crystallization does not cause principal loss, banks may have to undertake fresh transactions in the cash/spot market for replacing the failed transactions. Thus, banks may incur replacement cost, which depends upon the currency rate movements. Banks also face another risk called time-zone risk or Herstatt risk which arises out of time-lags in settlement of one currency in one centre and the settlement of another currency in another time zone. The forex transactions with counterparties from another country also trigger sovereign or country risk.

Fig III: Impact of Hedging on Expected Cash Flows of the Firm

9.1 TYPES OF EXCHANGE RISK Foreign exchange exposure can be broadly classified into 3 categories depending upon the nature of exposure: Transaction exposure

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Translation exposure Operating exposure

9.1.1 Transaction exposure It measures the risk involved due to change in the foreign exchange rate between the time, the transaction is executed and the time it is settled. Few foreign exchange transactions which may expose banks to transaction exposure are: • Purchase and sale of goods and services in foreign currency. • Loan repayments to be made in foreign currency. • Dividends paid or received in foreign currency.

9.1.2 Translation exposure It relates to valuation of foreign currency assets and liabilities at the end of accounting year at current realizable values at the end of accounting year. These losses/gains are also known as accounting losses /gains as they are notional and no real cash flows are involved. It involves greater significance for banks with branches operating in other countries and in different currencies.

9.1.3 Operating exposure It is a measure of sensitivity of future cash flows and profits of a bank to unanticipated exchange rate changes.

Figure IV: Conceptual Comparison of Differences among Operating, Transaction, and Translation Foreign Exchange Exposure

9.2 TOOLS AND TECHNIQUES FOR MANAGING FOREIGN EXCHANGE RISK Some of the various tools, available for hedging of foreign exchange risk are: A. Forward Contracts B. Futures C. Options

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D. Swaps

Forward Contracts It is an agreement to buy or sell foreign exchange for a pre-determined amount, at a predetermined rate and on a predetermined date; it involves cash flow on the date of delivery and not at the time of entering the contract. Futures Futures are forward contracts with standardized maturity date (1-6 months) governed by a set of guidelines stipulated by exchange concerned for settlements and payments. These are thus useful to hedge or convert known currency or interest rate exposures. Options It is a contract of future delivery of a currency in exchange for another, where the holder of the option has the right, without any obligation, to buy or sell the currency at an agreed price, the strike or exercise price, on a specified future date, but is not required to do so. • Call option is the right to buy • Put option is the right to sell. American options permit the holder to exercise at any time before the expiration date Swaps It is a financial transaction in which two counter parties agree to exchange streams of payments, or cash flows, over time, on the basis agreed at the inception of such arrangement. • Currency swap involves two parties agreeing to exchange specific amounts of two different currencies at the outset and to repay this overtime in installments, reflecting interest and principal. • Interest rate swap involves periodical exchange of interest payment streams of different characters. There are two main types: Coupon swaps: Fixed rates to floating rates. Basis swaps: Exchange of one benchmark for another under floating rates. Sometime currency and interest rate swaps are done together.

9 .3 STEPS IN FOREX RISK MANAGEMENT Benchmarking: Given the exposures and the risk estimates, the bank has to set its limits for handling foreign exchange exposure. The bank also has to decide whether to manage its exposures on a cost centre or profit centre basis. A cost centre approach is a defensive one and the main aim is ensure that cash flows of a firm are not adversely affected beyond a point. A profit centre approach on the other hand is a more aggressive approach where the firm decides to generate a net profit on its exposure over time.

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Hedging: Based on the limits a bank set for itself to manage exposure, the firms then decides an appropriate hedging strategy. As discussed earlier, there are various financial instruments available for the firm to choose from: futures, forwards, options and swaps and issue of foreign debt. Stop Loss: The bank’s risk management decisions are based on forecasts which are but estimates of reasonably unpredictable trends. It is imperative to have stop loss arrangements in order to rescue the bank if the forecasts turn out wrong. For this, there should be certain monitoring systems in place to detect critical levels in the foreign exchange rates for appropriate measure to be taken. Reporting and Review: Risk management policies are typically subjected to review based on periodic reporting. The reports mainly include profit/ loss status on open contracts after marking to market, the actual exchange/ interest rate achieved on each exposure and profitability vis-à-vis the benchmark and the expected changes in overall exposure due to forecasted exchange/ interest rate movements. The review analyses whether the benchmarks set are valid.

Forecasts

Risk

Estimation

FRAMEWORK FOR RISK MANAGEMENT

Benchmarking

Hedging

Stop Loss

Reporting and Review

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Fig V: Framework for Foreign Exchange Risk Management

9.4 STRATEGIES FOR FOREIGN EXCHANGE MANAGEMENT There are a number of alternative strategies that can be employed when managing foreign exchange risk: a) Do nothing - undertake currency transactions as they arise. b) Hedge known future obligations - this is the strategy that by default smaller Corporate uses. c) Use the time between the recognition of the foreign exchange exposure and the time that the foreign currency will be needed, to achieve the lowest price of the foreign currency. This can normally be most effectively achieved by a predetermined strategy that sets levels and trigger points to achieve purchasing targets. Both strategy (a) and (b) are commonly used as they are the easiest. They require no additional decision-making, they are administratively simple, and they have been the status quo for so long that some market participants aren't even aware those alternatives are available. However these two strategies have serious flaws the first is that they can carry a very high level of risk to the cash flows of the company. The reason that the risks are so high with these strategies is that they are extreme positions. To hedge every exposure means removing any chance that the market may move beneficially for the company, whilst its competitors may still enjoy the benefits of these price movements, in doing so the cash flows are at risk as competitors may lower selling prices and hence the profit margin is reduced because of diminished revenues as a direct result of hedging. To not cover any foreign exchange exposures leaves the company equally vulnerable to adverse movements in the exchange rate that could result in cost blowouts, and since cost increases are equally as harmful to margins as revenue decreases they also have explosive potential to undermine the profitability of the whole company.

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FUND TRANSFER PRICING Many international banks having different products and operate in various geographic markets have been using internal Funds Transfer Pricing (FTP). FTP is an internal measurement designed to assess the financial impact of uses and sources of funds and can be used to evaluate the profitability. It can also be used to isolate returns for various risks assumed in the intermediation process. FTP also helps correctly identify the cost of opportunity value of funds. FTP envisages assignment of specific assets and liabilities to various functional units (profit centers) – lending, investment, deposit taking and funds management. Each unit attracts sources and uses of funds. The lending, investment and deposit taking profit centers sell their liabilities to and buys funds for financing their assets from the funds management profit centre at appropriate transfer prices. The transfer prices are fixed on the basis of a single curve (MIBOR or derived cash curve, etc) so that asset-liability transactions of identical attributes are assigned identical transfer prices. Transfer prices could, however, vary according to maturity, purpose, terms and other attributes. The FTP provides for allocation of margin (franchise and credit spreads) to profit centers on original transfer rates and any residual spread (mismatch spread) is credited to the funds management profit centre. This spread is the result of accumulated mismatches. The margins of various profit centers are:

Deposit profit centre: Transfer Price (TP) on deposits - cost of deposits – deposit insurance- overheads. Lending profit centre: Loan yields + TP on deposits – TP on loan financing – cost of deposits – deposit insurance - overheads – loan loss provisions. Investment profit centre: Security yields + TP on deposits – TP on security financing – cost of deposits – deposit insurance - overheads – provisions for depreciation in investments and loan loss. Funds Management profit centre: TP on funds lent – TP on funds borrowed – Statutory Reserves cost – overheads. For illustration, let us assume that a bank’s Deposit profit centre has raised a 3 month deposit @ 6.5% p.a. and that the alternative funding cost i.e. MIBOR for 3 months and one year @ 8% and 10.5% p.a., respectively. Let us also assume that the bank’s Loan profit centre created a one year loan @ 13.5% p.a. The franchise (liability), credit and mismatch spreads of bank is as under:

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Profit Centers Deposit

Funds

Loan

Total

Interest Income

8.0

10.5

13.5

13.5

Interest Expenditure Margin

6.5 1.5

8.0 2.5

10.5 3.0

6.5 7.0

Loan Loss Provision (expected) -

-

1.0

1.0

Deposit Insurance Reserve Cost (CRR/ SLR) Overheads

0.1 0.6

1.0 0.5

0.6

0.1 1.0 1.7

NII

0.8

1.0

1.4

3.2

Table XV: Funds management profit centre – The liability, spread and mismatch spreads of a bank Under the FTP mechanism, the profit centers (other than funds management) are precluded from assuming any funding mismatches and thereby exposing them to market risk. The credit or counterparty and price risks are, however, managed by these profit centers. The entire market risks, i.e. interest rate, liquidity and forex are assumed by the funds management profit centre. The FTP allows lending and deposit raising profit centers determine their expenses and price their products competitively. Lending profit centre which knows the carrying cost of the loans needs to focus on to price only the spread necessary to compensate the perceived credit risk and operating expenses. Thus, FTP system could effectively be used as a way to centralize the bank’s overall market risk at one place and would support an effective ALM modeling system. FTP also could be used to enhance corporate communication; greater line management control and solid base for rewarding line management.

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VALUE AT RISK (VaR) aND DURaTION BaSED aLM 11.1 DEFINITION Value at risk or VaR is a maximum potential loss at a specified confidence level and specified horizon under normal market situation. For example, if a portfolio of stocks has a one-day 5% VaR of Rs 1 million, there is a 5% probability that the portfolio will fall in value by more than Rs 1 million over a one day period, assuming markets are normal and there is no trading. Informally, a loss which exceeds the VaR threshold is termed as “VaR break”.

11.2 THE IDEA BEHIND VaR The most popular and traditional measure of risk is volatility. For investors, risk is about the odds of losing money, and VaR is based on that commonsense fact. By assuming investors care about the odds of a really big loss, VaR answers the question, "What is my worst-case scenario?" or "How much could I lose in a really bad month?" A VaR statistic has three components: a time period, a confidence level and a loss amount (or loss percentage).

11.3 METHODS OF CALCULATING VaR Institutional investors use VaR to evaluate portfolio risk, but in this introduction we will use it to evaluate the risk of a single index that trades like a stock: the Nasdaq 100 Index, which trades under the ticker QQQQ. The QQQQ is a very popular index of the largest non-financial stocks that trade on the Nasdaq exchange. There are three methods of calculating VAR: the historical method, the variance-covariance method and the Monte Carlo simulation.

11.3.1. Historical Method The historical method simply re-organizes actual historical returns, putting them in order from worst to best. It then assumes that history will repeat itself, from a risk perspective.

11.3.2. The Variance-Covariance Method This method assumes that stock returns are normally distributed. In other words, it requires estimation of two factors - an expected (or average) return and a standard deviation - which allow to plot a normal distribution curve.

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11.3.3. Monte Carlo Simulation The third method involves developing a model for future stock price returns and running multiple hypothetical trials through the model. A Monte Carlo simulation refers to any method that randomly generates trials, but by itself does not tell anything about the underlying methodology.

11.4. USES OF VaR • • • •

Measure of trading portfolio (Market) Risk– extended to Credit and Operational Risks. Provision of capital for Business Units, to cover sudden losses. Limit Setting and Monitoring (Mid-office): If a trader loses more than e.g. 15% of capital (as per VaR) allocated to him, he should stop trading. Risk Adjusted Performance Measurement: If profits in both lines (e.g. bonds & FX) = Rs. 10, but VaR B= Rs. 20 and VaR FX= Rs. 30, then Risk Adjusted Return On Capital greater for bonds.

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I 64

2009

T AND SOFTWARE IN ALM

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IT and related software enable to build an integrated approach which combines liability models with that of asset allocation decisions have proved desirable and more efficient in that it can lead to better ALM decisions.

12.1 A TYPICAL ALM SYSTEM A typical ALM system consists of the following modules:

Administration

The administration module lets the administrator conduct various user activities as well as some distinct functions. The administrator can add a new user, modify or delete an existing user or lock / unlock a user. Various categories linked with a group of users can be set. This module sets up user-level permissions to access different options from the ALM system, depending on the category of the user.

Registration This module handles registration of the bank and its branches into the ALM system. Before extracting data from any branch, it is necessary to register the branch. The bank / branch ID and address are also updated in the database during registration.

Rule guide The rule guide is one of the most important modules in the system. Only the administrator has privileges to access this module for setting the various parameters of the ALM system. Data processing can be carried out only after all the required parameters have been set. The various functions performed by the module are: Enable / disable account heads: The user can enable or disable asset or liability account heads in the system. Account head maintenance: The user can add, modify or delete account heads with the help of this function. Percentage settings: Percentages can be defined to identify the 'bucket' for all those account heads that are of a percentage type (for example, 30 per cent in the first bucket, 50 per cent in the second bucket and 20 per cent in the third bucket). Bucket codes maintenance: The user can set various buckets for various reports. In case the buckets defined by the RBI for SLP, IRS, MAP or SIR changes, this function can be used.

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Settings of account heads to appear in a report: The user can select the account heads which should appear in a report, with the help of this function. i. RBI code mapping: This function lets the user map ALM account codes with the RBI account codes ii. Client code mapping: This function lets the user map ALM account codes with the client account codes. iii. Data process: This module allows the user to upload the data into the system manually or through a flat file for: Trial balance Residual accounts Parameterized accounts Bucket-wise accounts The user can set the 'as on date' and copy the data for one particular branch from the previous 'as on date' to the next 'as on date' with the help of this module.

Consolidation This has two sub-modules; pre-consolidation and consolidation. The pre-consolidation sub-module consolidates the balances of all the account heads branch-wise and puts them into appropriate time buckets, whereas the consolidation sub-module consolidates the data from all the branches and computes the figures at bank level into various time buckets reports: Structural liquidity profile (SLP) Interest rate sensitivity (IRS) Maturity and position (MAP) Statement of interest rate sensitivity (SIR)

Data analysis Data analysis projects the balance of any account head for any future date by three different methods — linear, polynomial and exponential — provided the historical data for two, three or more previous 'as on dates' is available with the system. The projected balances could be of any account head or any time bucket of an account head for the structural liquidity profile report. This is also known as forecasting. Data analysis also does simulations, with which an amount pertaining to any time bucket for any account can be altered and placed in a different time bucket, to see the overall impact on the structural liquidity and interest rate reports. This makes it much easier for the management to take decisions.

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Strengths The ALM system works on most easily available software and hardware platform User-defined account heads Generation of statutory returns System is capable of handling modules such as: Data analysis Data forecasting Interest rate simulation With new breakthroughs in technology, researchers tried to apply their findings in ways that are useful to institutional and private investors. In fact, some interesting softwares were created to cater the need of this niche market. In this section, some of them will be discussed. First of all, there is PROFITstar, which is an asset-liability management, budgeting and simulation application that can help in decision-making for institutions. It uses an integrated, strategic approach to managing financial goals and the position of institutions. Some of the other interesting features are that it helps to avoid inaccuracies that can result from relying solely on contractual maturity roll-off. Moreover, PROFITstar Interest Rate Sensitivity (IRSA) Matrix is able to simulate eight distinct rate swings and analyze their effects on income, capital and other key ratios. The software provider Surya is one that has developed products such as MitiGet (a market risk control system) and Balm (a bank asset liability management system). The following are some of the features of MitiGet: Tracks portfolio by exposure, stand-alone performance and relative performance. Tracks MTM and period returns. Has comprehensive cash flow definition module, modeling all dimensions of cash flow as random variables. Facilitates analysis of position, return and market risk on multiple and flexible dimensions such as industry, region, credit rating, market cap and liquidity. Facilitates dynamic grouping. Supports risk policy definition in terms of limits on both positions and value at risk. Supports two limits - soft and hard limits. Supports hierarchical and ’across the board’ concentration groups for limit definitions.

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Sensitivity and Scenario Analysis. Considering Balm, it facilitates measurements of: 1) Structural liquidity, and 2) Interest rate sensitivity. The liquidity module features of Balm are: Ability to compare cash flow mismatches across maturity spectrum, Can set tolerance limit for mismatch, The highlighting of maturity buckets that are under stress, The comparison of cash flow mismatches against tolerance limit. Following are the features of the interest rate sensitivity module: It segregates assets and liabilities into interest rate sensitive and non-interest rate sensitive categories. Further, interest rate sensitive assets and liabilities are sliced and distributed across seven maturity buckets. Maturity buckets that have mismatch between rate sensitive assets and rate sensitive liabilities are highlighted. Identifies components of assets and liabilities that contribute to mismatch in a given maturity bucket. This enables the user to initiate corrective action. Users can generate several interest rate scenarios across maturity buckets and evaluate their impact on Net Interest Income (NII).

Some other well known vendors are TCS, Oracle, and HCL etc. In case of UCO bank, about 50% of the branches are under CBS which covers 85% of the business while the rest 50% branches account for 15% of the banking business. The Data Centre is nodal point which is responsible for data from the CBS branches while the MIS team collects data from the non-CBS branches and then these two data are merged to create the STL statement that has to be provided to the RBI on a fortnightly basis. This data is also used in ALCO meetings held to primarily assess the liquidity situation, whether gap exists, whether the gap is within the prescribed prudential limit and whether the existing gap is beneficial or not. If the gap is not beneficial then reasons behind it and the probable solutions are discussed by ALCO.

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DATA COLLECTION Maturity pattern of certain items of Assets and Liabilities only is published in the Bank’s Annual Report. As other data is not made available to public, an approximation has been made based on the actual Data of the bank to reflect a hypothetical Asset Liability profile of UCO Bank, based on which the Project Study has been built up.

13.1 ALM: CASE STUDY OF A BANK

Microsoft Office Excel 2003 Workshee

In order to collect data for the case study, the hypothetical data of a bank is developed. To attain this objective as well as to deal with a realistic scenario, the annual reports of CO bank are studied and accordingly a close approximation is developed. Let us name the bank as Lord Mahaveer Bank whose Structural Liquidity Statement (STL) of the bank is obtained by approximation and adjustment of the data of UCO bank..

13.2 DATA ANALYSIS Analysis of the STL in the normal scenario: In the normal scenario, we find that the cumulative mismatch as percentage of cumulative outflows ratios are well within the prudential limits provided by RBI and that the bank is dealing with short-term assets(in the maturity buckets from 1-28days) and long-term liabilities(in the maturity buckets from29 days-above 5 years). There lies a negligible gap between the maturity of the assets and liabilities within the prudential limits. We can see that the bank is not deploying the funds according to maturity profile of the liability. This may be due to: Bank is presuming an increase in the interest rate and so is holding its funds in the short term to deploy when the rate rises. When the rate goes up there will be increase in NII.Then more of bank’s assets will reprice at a higher rate than liabilities and therefore, revenue will increase more than the cost of borrowed funds. But considering the present economic condition, there is a scarce chance that rates will rise considerably, may be it can increase by a quarter basis points. But if the trend continues without any change in the interest rate then there will be decrease in NII.

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Bank is following a conservative approach i.e. to hold funds rather than deploy it so that it does not bear the risk to be a defaulter of payment. Bank is bearing this opportunity loss to maintain its image in the market. Bank probably has less number of borrowing lines available in the market and thus it cannot rely on emergency borrowing from the market and is maintaining a cushion from its long term liabilities to meet the emergencies rather than resorting to market borrowing.

Options available to the bank: The bank has a comfortable liquidity position in the long term but it should improve on its asset position in the long term by suitable deployment of funds so that opportunity loss is minimized and NII is improved. Funds can be deployed in three ways which are discussed below in order of preference: 1. Equity: Deploying funds in equity market is a comparably safe option since at present the sensex is recovering and bank will enjoy quick returns and capital gain. 2. Loans: In this case, the bank is exposed to credit risk considering chances of default of payment. Thus, though the yield is attractive in case of loans, in case of default, the bank has to bear the cost of capital. 3. Investments: There are two choices available in case of investments: Investments in floating rate bonds: Here the risk is minimized as the floating rate bonds can be hedged. Two situations can be there:



If the interest rate rises then the bank should not do anything as it is receiving float and paying fixed.



If the interest rate falls, then the bank can hedge to IRS and receive fixed and pay float.

Investments under Government securities: This is the least preferable option. Here also two situations can arise: • If the interest rate rises, the bank may receive float and pay fixed. • If the interest rate falls, then the bank may do nothing and continue to receive fixed and pay float.

Considering the reverse situation, in the normal scenario we get

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ASSET LIABILITY MANAGEMENT Statement of structural liquidity under normal scenario Cumulative mismatch as % to cumulative outflows Prudential limits

Day 1

-287.43% -5.00%

2-7 Days

-94.03% -10.00%

8-14 Days -83.37% -15.00%

15-28 Days -38.51% -20.00%

29 Days & upto 3 Months 9.34% -30.00%

2009

Over 3 months & upto 6 Months 8.09%

Over 6 Months & upto 1 Yr

Over 3 Yr & upto 3 Yrs

20.71%

17.82%

-30.00%

-35.00%

-30.00%

Over 3 Yrs & upto 5 Yrs 8.15%

Above 5 Yrs

-15.00%

-10.00%

It is found that the bank has leveraged short term liabilities with long term assets and has strain in its immediate liquidity position. The bank has bridged the prudential limits and is a completely outlier facing serious liquidity risk problems. The options available to the bank are: 1. Bank may liquidate its assets i.e. loans and investments taking into account the cost involved. 2. Bank may sell its investments even at loss considering the situation. 3. Bank may go for securitizations i.e. sell its loan portfolio. 4. Bank may tap known resources at very attractive rates for borrowing for 1 or 3 years or 3-6 month’s period.

FINDINGS AND RECOMMENDATIONS Following the assumptions of RBI for crisis scenario, the STL for market specific crisis and bank specific crisis conditions are developed.

14.1 LIQUIDITY UNDER CRISIS SCENARIO A. Estimation of liquidity under Bank’s Specific Crisis Scenario Estimating liquidity under Bank’s Specific Crisis Scenario would involve recasting of Structural Liquidity Statement as provided below:

Assumptions by regulator: 1. Substituting 15% of total outstanding advances as NPA and in place of NPA included in structural liquidity statement 2. Reworking the term loan repayment schedule by assuming a 5% restructuring of outstanding term loans and deferment of repayment by one year. The same would apply on repayment obligation of other constituents excluding counter parties 3. Non renewal of bulk deposits that are falling due over next three months

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1.40%

ASSET LIABILITY MANAGEMENT 2009

Analysis of the STL under bank specific crisis scenario: In this case the situation is quite grave with negative cumulative mismatch percentages which are beyond the prudential limits in all but the last 3 maturity buckets. The bank has more RSLs than RSAs in all the buckets. The bank will be benefitted if the interest rate decreases. Mostly the mismatch percentages deviated from prudential limits in the first 3 buckets, the highest being in the first bucket with liabilities much exceeding the assets.

Options available to the bank: 1. The bank may try to create funds by emergency borrowing for 1-2 months at a slightly higher rate than the prevailing market rate of interest. 2. Bank may raise the interest rate suitably over and above the competitors to attract short term depositors. The bank can introduce some tailor-made products (For example- Fixed Deposit Schemes @ 8% for a lock-in period of 100-150 days, etc). 3. Liquidity Adjustment Facility: RBI can act as the last resort of the bankers through liquidity adjustment facilities like reverse repo, etc. 4. Back Stop Facility: RBI may provide the bank with the liquidity support at the bank rate under Collateralized Lending Facility (CLF) which is available to each scheduled bank at a level of 0.125% of its average aggregate deposits. 5. Export Reference Facility: RBI provides refinance facilities to the extent of 15% against eligible exports. These refinance facilities are presently provided up to 50% as normal refinance and remaining 50% as back stop facility while normal refinance facility is at Bank Rate, back stop facility is at variable rate. Bank may utilize these refinance facilities to tide over temporary liquidity need. 6. The bank may avoid taking additional commitment. 7. The bank may dispose its long-term investment, judicially at a minimum cost. 8. The bank may sell its loan portfolio to other banks to raise funds. 9. The bank may try to borrow from some of its clients with whom they enjoy good relations. 10. The bank may use relationship with correspondent banks for short term requirements subject to prudential limits of 25% of Tier I capital.

14.2. ESTIMATION OF LIQUIDITY UNDER MARKET CRISIS SCENARIO Estimating liquidity under Market Crisis Scenario would involve recasting of Structural Liquidity Statement as provided below:

Assumptions by regulator: 1. 10% reduction in investment portfolio may be incorporated to account for the market crisis arising out of drying up of liquidity in the market. 2. Non renewal of bulk deposits that are falling due over next three months.

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Analysis of the STL under market specific crisis scenario: Though there are negative mismatch percentages beyond the prudential limits, the situation is not as grave as the bank specific crisis situation.

Options available to the bank: The assumptions are severe in bank-specific crisis than in market-specific crisis, as the latter is universal it requires RBI’s active intervention. The prudential limits which are valid for normal market situation may be under pressure under sustained illiquid and credit crisis scenario. Under these circumstances, 1. The bank can approach RBI for liquidity. 2. The RBI may tweak – the CRR and or SLR as it happened during the Dec’08 Qr to infuse liquid funds /liquidity into the system. 3. RBI can increase refinance facility.

CONCLUSION The study undertaken in course of the project not only introduced asset liability management but also revealed various sensitive aspects related directly and indirectly to the subject. Overall successful functioning of asset liability management begins with proper co-ordination and collection of data from the branch levels (CBS as well as non CBS) throughout India. This is followed by mapping the data as per guidelines and analyzing the data. Analysis of data also includes scenario analysis in order to apprehend and avoid serious asset liability problems. Subsequently, solutions to such problems or indications to the same are developed. The decisions taken are formulated into action plans to be followed thereafter, along with abidance by the prevailing policies and procedures for the overall smooth running of the bank. The aspect of scenario analysis, in a simplified form is taken up for the case study whereby in the normal situation it is found that the bank is in dealing with short term assets and long term liabilities and the various probable reasons to this are discussed. Further, the options available in this regard are sited. When the regulators’ assumptions for bank specific crisis are loaded on the normal scenario the situation turned out to be grave requiring emergency funding. But considering the normal scenario, this could not be relied upon as the sole option available and thus other probable course of action are discussed. However, the market specific crisis was less serious when compared to the bank specific one owing to the general assumptions of the regulator.

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Thus, it is found that the bank exercises an overall conservative approach which, if made more flexible to an extent, will help the bank better cope with either crisis situations or mere fluctuations in the market.

CONSTRAINTS AND LIMITATIONS 1. The main constraint prevails in form of sensitive data and its collection. Limited data is provided in public domain which was an impediment. Thus, an organized study considering previous years’ data in its entirety could not be achieved and a hypothetical data based on approximation, has been made. 2. The time period was also a constraint considering the vastness and details involved in the subject. 3. The technical nature of the study has helped to gather practical knowledge to a large extent but the conclusion drawn is based on researcher’s limited knowledge in this subject.

SCOPE FOR FURTHER STUDY The study opens up scope for further research on Hedging mechanism and the selection of suitable strategies. Pricing an asset or a liability product with a view to bridge the gaps. Scenario analysis and back testing of the outcome with the actual.

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Annexure I Name of the Bank: Statement of Structural Liquidity as on: (Amount in crores of Rupees) Residual Maturity Profile OUTFLOWS

1 Day

2-7 Days

8-14 Days

15-28 Days

29 Days up to 3 month s

Over 3 months and up to 6 months

Over 6 months and up to 1 Year

Over 1 year and up to 3 years

Over 3 years and up to 5 years

Over 5 years

Total

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

1. Capital 2. Reserves and Surplus 3. Deposits (a)Current Deposits (b)Savings

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Bank Deposits (c)Term Deposits (d) Certificates Deposit

of

4.Borrowings

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

5. Other XXX Liabilities & Provisions

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

(a)Call and Short Notice (b)InterBank (Term) (c) Refinances (d) Others (Specify)

(a) Payable

Bills

(b) Provisions (c) Others 6. Lines of XXX Credit committed to (a) Institutions (b) Customers

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7. Unavailed portion of Cash Credit / Overdraft / Demand Loan component of Working Capital

8. Letters of Credit / Guarantees 9. Repos 10. Bills Rediscounted (DUPN) 11. Swaps (Buy / Sell) / maturing forwards

12. Interest payable 13. Others (Specify) A. TOTAL OUTFLOWS B. CUMULATIVE OUTFLOWS (Amount in crores of Rupees) Residual Maturity Profile

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INFLOWS

1 Day

2-7 Days

8-14 Days

15-28 Days

29 Days up to 3 months

Over 3 months and up to 6 months

Over 6 months and up to 1 Year

Over 1 year and up to 3 years

Over 3 years and up to 5 years

Over 5 years

Total

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

1. Cash

2. Balances with RBI 3. Balances with other Banks (a)Current Account (b)Money at Call and Short Notice, term Deposits and other placements 4. Investments (including those under Repos but excluding Reverse Repos) 5. Advances (Performing) (a) Bills Purchased and Discounted (including bills

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under DUPN)

(b) Cash Credit, Overdrafts and Loans repayable on demand (c) Term Loans 6. NPAs (Advances and Investment)* 7. Fixed Assets

8. Other Assets

XXX XXX

XXX XXX

XXX

XXX

XXX

XXX

XXX

XXX XXX

(a)Leased Assets

(b)Others

9. Reverse Repos

10. Swaps (Sell / Buy) / Maturing Forwards 11. Bills Rediscounted (DUPN) 12. Interest payable 13. Committed Lines of Credit

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14. Export Refinance from RBI 15. Others (Specify) C. TOTAL INFLOWS

D. MISMATCH (C-A) E. MISMATCH as % to OUTFLOWS (D as % to A)

F. CUMULATIVE MISMATCH G. CUMULATIVE MISMATCH as a % to CUMULATIVE OUTFLOWS (F as a % to B)

Net of provisions, interest suspense and claims receivable from ECGC / DICG

Annex II Guidance for slotting the future cash flows of banks in the revised time buckets Heads of Accounts Outflows 1. Capital, Reserve and surplus 2. Demand Deposits (Current and Savings Deposit )

81

Classification into time buckets ‘Over 5 years’ time bucket Savings Bank and Current Deposits may

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be classified into volatile and core portions. Savings Bank (10%) and Current (15%) Deposits are generally withdrawable on demand. This portion may be treated as volatile. While volatile portion can be placed in the Day 1, 2-7 days and 8-14 days time buckets, depending upon the experience and estimates of banks and the core portion may be placed in over 1- 3 years bucket. The above classification of Savings Bank and Current Deposits is only a benchmark. Banks which is better equipped to estimate the behavioural pattern, roll-in and roll-out, embedded options, etc. on the basis of past data/empirical studies could classify them in the appropriate buckets, i.e. behavioural maturity instead of contractual maturity, subject to the approval of the Board/ALCO. 3. Term Deposits

Respective maturity buckets. Banks which are better equipped to estimate the behavioural pattern, roll-in and roll-out, embedded options, etc. on the basis of past data/empirical studies could classify the retail deposits in the appropriate buckets on the basis of behavioural maturity rather than residual maturity. However, the wholesale deposits should be shown under respective maturity buckets. (wholesale deposits for the purpose of this statement may be Rs 15 lakhs or any such higher threshold approved by the bank’s Board).

4. Certificate of Deposits

Respective maturity buckets. Where call/put options are built into the issue structure of any instrument/s, the call/put date/s should be reckoned as the maturity date/s and the amount should be shown in the respective time buckets.

5. Other Liabilities and provisions (i)Bills Payable

(i) The core component which could reasonably be estimated on the basis of past data and behavioural pattern may be shown under ‘Over 1-3 years’ time bucket. The balance amount may be placed in Day 1, 2-7 days and 8-14 days buckets, as per

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(ii) Provisions other than for loan loss and depreciation in investments (iii) Other Liabilities

Heads of Accounts Inflows 1. Cash 2. Balances with RBI

3. Balances with other Banks (i)Current Account

(ii) Money at Call and Short Notice, Term Deposits and other placements 4. Investments (i)Approved securities

(ii) Corporate debentures and bonds, PSU bonds, CDs and CPs, Redeemable preference shares, Units of Mutual Funds (close ended), etc (iii)Shares (iv)Units of Mutual Funds (open ended) (v) Investments in Subsidiaries/ Joint Ventures (vi) Securities in the Trading Book

5. Advances ( Performing )

behavioural pattern. (ii) Respective buckets depending on the purpose. (iii) Respective maturity buckets. Items not representing cash payables (i.e. income received in advance, etc.) may be placed in over 5 years bucket.

Classification into time buckets Day 1 bucket While the excess balance over the required CRR/SLR may be shown under Day 1 bucket, the Statutory Balances may be distributed amongst various time buckets corresponding to the maturity profile of DTL with a time-lag of 14 days. (i) Non-withdrawable portion on account of stipulations of minimum balances may be shown under ‘Over 1-3 years’ bucket and the remaining balances may be shown under Day 1 bucket. (ii) Respective maturity buckets.

(i) Respective maturity buckets, excluding the amount required to be reinvested to maintain SLR corresponding to the DTL profile in various time buckets. (ii) Respective maturity buckets. Investments classified as NPIs should be shown under over 3-5 years bucket (substandard) or over 5 years bucket (doubtful). (iii) Listed shares (except strategic investments) in 2-7days bucket, with a haircut of 50%. Other shares in ‘Over 5 years’ bucket (iv) Day 1 bucket (v) ‘Over 5 years’ bucket. (vi) Day 1, 2-7 days, 8-14 days, 15-28 days and 29-90 days according to defeasance periods. Provisions may be netted from the gross

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investments provided provisions are held security-wise. Otherwise provisions should be shown in over 5 years bucket. 6. Non-Performing Assets 7. Other Assets

8. Lines of Credit committed / available (i) Lines of Credit committed to/ from Institutions (ii) Unavailed portion of Cash Credit/ Overdraft / Demand loan component of Working Capital limits (outflow)

(iii) Export Refinance – Unavailed (inflow)

Sub-standard assets may be shown over 3-5 years bucket and Doubtful and Loss Assets to be shown over 5 years bucket. Intangible assets Intangible assets and assets not representing cash receivables may be shown in ‘Over 5 years’ bucket.

(i) Day 1 bucket. (ii) Banks should undertake a study of the behavioural and seasonal pattern of potential availments in the accounts and the amounts so arrived at may be shown under relevant maturity buckets up to 12 months (iii) Day 1 bucket.

BIBLIOGRAPHY 1. “Risk Management Policy & Asset Liability Management Policy 2006-07”, UCO Bank 2. RBI Circular on Asset Liability Management System in Banks issued in February, 1999 3. Guidance Note on Market Risk Management issued by RBI in October 2002. 4. www.wikipedia.com, free encyclopedia- Asset Liability Management, VaR, VaR Models. 5. www.forexriskmngmnt.com

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6. www.rbi.com 7. www.fedai.com 8. www.riskglossary.com 9. www.riskbook.com 10. www.investopedia.com 11. Risk Management and Financial Derivatives by Satyajit Das, McGraw Hill 12. Basel II – Integrated Risk Management Solution 13. Bank for International Settlement, Asset Liability Management 14. Bank Management by Hempel, Simonson and Coleman 15. Bank Management by SinkeyRediff News- Why is Risk Management important?, by Nupur Hetamsaria 16. Risk Management by Indian Institute of Banking & Finance, Macmillian

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