Banks hold different categories of assets and liabilities with different
maturities carrying different interest rates. The bank’s ability in matching
this asset and liability structure results in improving its returns. Asset liability
management involves managing different risks such as interest rate risk, credit
risk, operational risk, exchange rate risk, market risk, liquidity risk,
contingency risk and treasury management risk.
Variations in interest rates will impact the value of assets and
liabilities that a bank holds. Therefore they need to devise tools and
techniques to handle the impact of these changes. Interest rate risk management
helps in maximizing bank profits and reduces losses and protects bank assets. The
nature of banks having a smaller capital base compared to the larger asset base
makes banks vulnerable to capital erosion due to reduction in value of assets.
Bank balance sheet before capital erosion
|
Liabilities
|
Assets
|
|||
|
Capital
|
20000
|
Reserves
|
85000
|
|
|
Borrowings
|
10000
|
Advances
|
588000
|
|
|
Short term deposits
|
550000
|
Investments
|
100000
|
|
|
Long term deposits
|
200000
|
Fixed Assets
|
7000
|
|
|
Total
|
780000
|
Total
|
780000
|
Bank balance sheet after capital erosion on account of 2% value
reduction in advances shows a 58.8% reduction in capital.
|
Liabilities
|
Assets
|
|||
|
Capital
|
8240
|
Reserves
|
85000
|
|
|
Borrowings
|
10000
|
Advances
|
576240
|
|
|
Short term deposits
|
550000
|
Investments
|
100000
|
|
|
Long term deposits
|
200000
|
Fixed Assets
|
7000
|
|
|
Total
|
768240
|
Total
|
768240
|
There are several models of risk management through asset liability
management. They are asset models, liability models, randomness models,
multi-dimensional models and computer aided asset liability management (CALM)
models. Asset models and liabilities models focus on one aspect of the balance
sheet. The randomness model is based on selected criteria that impact the bank
performance. Multi-dimensional models look at impact of selected variables on
several independent variables. The CALM models are comprehensive and aim at
dynamic asset liability management.
In managing risks banks need to focus attention on volume, mix,
maturity, rate sensitivity, quality and liquidity and acceptable risk reward
ratio. The parameters for ALM are net interest margin, market value of equity
and economic equity ratio.
Reserve Bank of India has provided guidelines in terms of asset
liability management. The traditional approach focuses on operational limits on
credit, loan provisioning, portfolio diversification and collateralization. The
innovative methods suggested include loan securitization, capital adequacy and
derivative products.
For successful risk management by banks, well developed money market,
trading in repo transactions, forward trading, underwriting facilities and
derivative markets are essential.
Gap Analysis
The technique used by banks to analyze the impact of interest rate
changes on the assets, liabilities and net worth. Gap is the difference between
rate sensitive asset and rate sensitive liabilities. A negative gap is
associated with increase in interest rates and a positive gap is associated
with decline in interest rates. Estimated loss is computed with reference to
value change within each time bucket and aggregate difference between assets
and liabilities.
|
Liabilities
|
Assets
|
|
|
Rate Sensitive Liabilities
|
Rate Sensitive Assets
|
|
|
Fixed Rate Liabilities
|
Fixed Rate Assets
|
|
|
Total
|
Total
|
A positive funds gap shows financing of
rate sensitive assets by fixed rate liabilities. A negative funds gap on the other
hand shows fixed rate assets financed by rate sensitive liabilities.
Example
|
Liabilities
|
Assets
|
|||
|
Rate Sensitive Liabilities
|
Rate Sensitive Assets
|
|||
|
Short term deposits
|
550000
|
Advances
|
145000
|
|
|
Fixed Rate Liabilities
|
Investments
|
100000
|
||
|
Borrowings
|
10000
|
Reserves
|
85000
|
|
|
Long term deposits
|
200000
|
Fixed Rate Assets
|
||
|
Advances
|
443000
|
|||
|
Capital
|
20000
|
Fixed Assets
|
7000
|
|
|
Total
|
780000
|
Total
|
780000
|
|
Liabilities
|
Assets
|
|||
|
Rate Sensitive Liabilities
|
Rate Sensitive Assets
|
|||
|
Short term deposits
|
550000
|
Advances
|
145000
|
|
|
Investments
|
100000
|
|||
|
Reserves
|
85000
|
|||
|
Fixed Rate Assets
|
||||
|
Advances
|
220000
|
|||
|
Fixed Rate Liabilities
|
Fixed Rate Assets
|
|||
|
Borrowings
|
10000
|
Advances
|
223000
|
|
|
Long term deposits
|
200000
|
|||
|
Capital
|
20000
|
Fixed Assets
|
7000
|
|
|
Total
|
780000
|
Total
|
780000
|
Total
Rate Sensitive Assets (RSA) = 330000
Total
Rate Sensitive Liabilities (RSL) = 550000
Funds
Gap = 220000 (Negative Gap)
A conservative bank maintains a positive gap and gains from increase in
interest rate. An aggressive bank maintains a negative gap and gains from
decrease in interest rate. The net interest income likely to affect the bank
due to changing interest rate scenarios can be computed by multiplying change
in rate with the gap.
Other ways of representing gap include relative gap and gap ratio. When
a bank has a positive gap a possible management action at times of rising
interest rates would be to increase rate sensitive assets or reduce rate
sensitive liabilities. Another possible action is to extend liability maturity
or shorten asset maturities. If on the other hand interest rates are falling, a
reverse action will be initiated.
Duration Analysis
Duration analysis aims at maximizing market value of equity. Duration is
computed taking weighted average of cash flows of an instrument discounted to
present time. Duration gap is computed subtracting weighted liabilities
duration from asset duration. The weights are computed by dividing total
liabilities by total assets.
Duration analysis assumes precise knowledge of duration of assets and
liabilities, market value of assets, a flat interest rate structure, no impact
of convexity on valuation and a parallel shift in the change of interest rates.
Computation of duration gap
|
Assets
|
Liabilities
|
|
T Bill
Investment
|
Certificate
of Deposit
|
|
1 year 7% 30
|
1 year 6% 50
|
|
Loan 2
year 10% 70
|
3 Year Time
Deposit 8% 40
|
|
Capital 10
|
|
|
100
|
100
|
When rates increase by 2%
|
Assets
|
Discounted Cash Flows
|
|
T Bill : 32.70
(1 + 0.09)
|
30.00
|
|
Loan:
7.00 = 6.25
(1 + 0.12)
77.00 = 61.38
(1 + 0.12)2
|
67.63
|
|
Asset Value
|
97.63
|
|
Liabilities
|
Discounted Cash Flows
|
|
1 Year CD = 54.00
(1 + 0.08)
|
50.00
|
|
3 Year TD = 3.60 =
3.24
(1 + 0.11)
= 3.60 =
2.92
(1 + 0.11)2
= 43.60 =
31.88
(1 + 0.11)3
|
38.04
|
|
Total Liabilities
|
88.04
|
|
Market Value of Bank
Capital (97.63 – 88.04)
|
9.59
|
|
Additional Income - (-20 x 0.02)
|
0.40
|
|
Decline in Capital Value of
Bank (10 – 9.59 – 0.40)
|
0.01
|
|
Book Value of Bank Capital
|
10.00
|
|
Assets
|
Duration
|
|
T Bill :
|
1.000
|
|
Loan :
|
1.908
|
|
Weighted Average duration 0.30 x 1.000
0.70 x 1.908
|
1.635
|
Impact on equity
|
Equity
|
Value
|
|
|
|
|
|
0.9
0.02
|
|
|
-0.063
|
|
Macauley’s Duration
|
-0.057
|
|
Decline in Equity Value (Duration Gap)
|
-0.010
|
Summary of impact of duration gap on changing
interest rate scenarios can be stated as follows.
|
Duration Gap
|
Interest rate Change
|
Assets
|
|
Liabilities
|
Equity
|
|
Positive
|
Increase
|
Decrease
|
>
|
Decrease
|
Decrease
|
|
Positive
|
Decrease
|
Increase
|
>
|
Increase
|
Increase
|
|
Negative
|
Increase
|
Decrease
|
<
|
Decrease
|
Increase
|
|
Negative
|
Decrease
|
Increase
|
<
|
Increase
|
Decrease
|
|
Zero
|
Increase
|
Decrease
|
=
|
Decrease
|
No change
|
|
Zero
|
Decrease
|
Increase
|
=
|
Increase
|
No change
|
Immunization is the process of achieving a
zero duration gap. Immunization of bank portfolio is optimum when the gain from
the higher reinvestment rate is offset by capital loss and the change in
capital is insensitive to changes in interest rate fluctuations.
Derivatives in ALM
Financial derivative instruments are
instruments of risk management used by banks for hedging expected variations in
returns or values. Some of the derivative instruments used by banks to hedge
their interest rate risk are forward rate agreements, futures, options, swaps,
caps, floors and collars. Forward rate agreements are contracts where a bank
anticipating increase or decrease in interest rates enters into a contract with
counterparty for exchange of values at predetermined rates. Futures are similar
contracts where banks take position to settle contracts at current rates on a
future date. These contracts are marked to market and are for a fixed duration.
Options are contracts that provide a right to buy or sell at an agreed rate an
instrument on a future date. Caps, floors and collars provide the upper and
lower limits for interest rate fluctuations which triggers a contract on the banks.
Swaps aim at exchange of fixed rate instruments to fluctuating rate instruments
at predetermined rates on a future date.
Swaps
Hedge Positions
Hedge: Long Futures: Hedge:
Short Futures:
loss when rates falls loss when rates rise
Futures Profile
A) Profit or loss for buyer of futures B) Profit or loss for
seller of futures
Options Profile
A) Profit or loss for buyer of call B) Profit or loss for buyer
of put option option and buyer of
futures option
and seller of futures
Caps
Floors
Collar
Interest rate risk management
The strategies adopted by banks to manage
interest rate risks may be broadly classified into two categories. The first is
the rearrangement of balance sheet that includes duration gap management. The
second is the off-balance sheet adjustment through instruments such as interest
rate swap, hedging with financial futures, insurance and risk transfer.
Some of the causes for risk from off
balance sheet activities include contingent liabilities, guarantees, standby
letters of credit, loan commitments and note issue facilities given by banks.
Securitization of loan wherein a debt instrument is issued by a bank based on
expected revenues from a defined pool of loans is a strategy used by banks to
transfer loan risks to market.
Hedging
•
Example - Interest-rate forward contract
•
Purchase of T-Bills with a maturity of one
year.
Advantages
•
Risk of increased interest rate is
reduced
•
Flexibility can be incorporated in the
contract if they are traded in the Over-The-Counter (OTC) market.
Disadvantages
•
OTC contracts have less liquidity
•
Default risk to the bank
Questions
1. What is asset liability management?
2. Explain the steps in asset liability management
process.
3. What is gap analysis? How is it performed?
4. What is duration analysis? Explain the methodology.
5. How is interest rate risk managed by banks?
6. What are derivatives?
7. How are derivatives used by banks for interest rate
risk management?
8. What are off balance sheet items? What type of risks
banks face in holding off balance sheet items?
9. What are the assumptions behind duration analysis?
10. Discuss the technique of interest rate risk management
used by bank.
11. Determine the gap for a bank with an asset sensitive
value of 49 crore and liability sensitive value of 120 core.
12. Determine if a bank is conservative or aggressive if
it has a positive gap position.
13. Determine the change in interest rate income if gap is
36 crore and expected change in interest rate is 50 basis points.
14. Determine the relative gap if total assets of a bank
are 1000 crore, rate sensitive assets are 75 crore and rate sensitive
liabilities are 65 crore.
15. Determine the gap ratio if rate sensitive assets of a
bank are 500 crore and rate sensitive liabilities are 750 crore.
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