ALM Implementation in Banks

Dr. S. S. Satchidananda D. N. Prahlad

International Institute of Information Technology Bangalore

CBIT-IIITB Working Paper WP-2006-4

ALM Implementation in Banks

ABSTRACT Implementing Asset Liability Management (ALM) function in banks is not only a regulatory requirement in India but also an imperative for strategic bank management. ALM brings to bear a holistic and futuristic perspective to the balance sheet management. This paper sets out the ALM framework and the technology requirements. It also provides guidance for implementation. The problems in ALM implementation are identified and focused for resolution.

Working Paper - 4

Dr. S. S. Satchidananda D. N. Prahlad

CBIT Centre of Banking and Information Technology International Institute of Information Technology 26/C, Electronics City Bangalore 560 100
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Dr. S. S. Satchidananda (sssatchidananda@iiitb.ac.in) is Research Director and Professor of Banking and Finance at the Centre of Banking and Information Technology, IIITB.

D N Prahlad is Managing Director, Surya Software Systems Pvt Ltd., Bangalore The views expressed in the paper are those of the authors and does not necessarily reflect the position of the organizations they belong to.
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Table of Contents
I. II. III. IV. ALM Conceptual Framework Strategising ALM in Banks A Model for Implementation Issues in ALM Implementation in Banks 1 2 4 4

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Asset Liability Management (ALM) Implementation in Banks

I. ALM Conceptual Framework
Overview
Asset Liability Management (ALM) is essentially management of the timing and the value of the cash flows in banks and the consequential risks. ALM assumes critical significance in banking because the banks typically borrow short and lend long and therefore, the mismatch between cash inflows and cash outflows is inherent in banking. The fact that the banks are highly leveraged institutions with their operations being 10 to 12 times their own funds exacerbates the problem. Interest rate volatility and the high-voltage competition of the modern financial marketplace and exploding expectations from customers make the matters more difficult. Therefore, ALM becomes an essential strategy for survival by focusing on the dynamic relationship between the patterns of cash inflows and cash outflows. Asset Liability Management is defined as the process of adjusting bank liabilities to meet loan demands, liquidity needs and safety requirements. It is different from the passive acceptance of deposit liabilities from the public for regular intermediation and maturity transformation into assets. AL Management is a philosophy under which the banks can target asset growth by adjusting liabilities to suit their needs. Therefore, management of assets and liabilities becomes a vital bank management function. The focus of AL Management should be the bank profitability and long term operating viability. The short term objective of ALM in a bank is to ensure liquidity while protecting the earnings and the long term goal is to maximize the economic value of the bank i.e. the present value of banks expected net cash flows, defined as the expected cash flows on assets minus the expected cash flows on liabilities plus the expected net cash flows on off balance sheet (OBS) positions. (Basel Committee on Banking Supervision) Other objectives of ALM are: Maximizing profitability Minimizing of capital Ensuring structural liquidity Ensuring robustness in market risk management Risks addressed by ALM are liquidity risk and the interest rate risk. However, it is important to note that risk management of any kind requires the ALM strategies and operations. information and this requires extensive computerization of the bank, so that the requisite information becomes readily available. In fact, the benefits of the application of Information Technology for building a robust and rich information system are well known. The Board of Directors would have the overall responsibility for the ALM & risk management and should lay down the tolerance limits for liquidity and interest rate risk in line with the organizations 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. Needless to say ALCO has to be 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. 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. For instance, the trading book securities are to be shown under one day to 30 days, over 1 month & up to 2 months, etc., time buckets on the basis of defeasance periods. Guidelines also provide a format for estimating shortterm 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, banks need to estimate the future behavior of assets and liabilities and off--balance sheet items in response to changes in 1

ALM Organization

ALM Process

Three Pillars of ALM

ALM involves the following: There should be a proper management information system which provides accurate and adequate

ALM Information System

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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.

Mapping Non-term products

Structural Liquidity Risk

Liquidity risk is the inability to handle adverse clearing. Profiles of inflows and outflows are mismatched over time causing 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. There are other measures as well. Cost to close gap technique may be used as a measure of liquidity risk. Seven-day Maximum cumulative outflow is another technique that is used for this purpose.

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 mature in later time buckets. Volatile portion is typically assigned to the first bucket.

Probabilistic cash flow products

Interest Rate Risk

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.

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 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. Traditionally, banks have a trading book and a banking book. The Basel Committee also uses this differentiation. The essential distinction between a banking book and a trading book is in the method used for the recognition of the risks and valuation. While the items in the trading book are marked to market at frequent intervals and the valuation is done on the basis of dynamic prices, the banking book items are typically valued on the balance sheet date, either at market value or at book value. For purposes of determining interest rate sensitivity, both books may be mapped to zero coupon bonds, preserving market risk. Combined book represents a reasonable estimate of banks interest rate risk profile. The application of techniques like modified or dollar duration gap and convexity gap analysis to such a profile will enable risk measurement of interest rate sensitivity.

Options, Futures and derivatives

Bank uses these instruments to hedge positions. To offer a customer a long position in US Dollar at a certain rate, bank has to hedge by taking a corresponding short position. Thus, regardless of US Dollar rate changes, bank is fully protected, offering customer protection as well. Thus, 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 deposittaking 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.

II. Strategising ALM Framework

ALM policy is drafted and updated by banks ALCO. ALM policy requires that board of directors, Asset Liability committee follow a formal procedure. ALM Policy covers banks position on all risks credit risk, market risk, liquidity risk etc. Banking keeps changing 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.

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.

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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. Even plain vanilla deposits need to be priced and priced by timeframe. 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.

Tolerance to limits of cost to close is defined as a measure of structural liquidity risk and this is used for control. Maximum Cumulative Outflow Maximum cumulative outflow analysis is measured in number of days. 7 day MCO is used as a practical measure. This simply adds up all cumulative outflows. No inflows are considered. Thus, this measure indicates a sum of all possible cash outflows in seven-day period. Tolerance on MCO may be another measure to improve structural liquidity control. Scenario Analysis Liquidity analysis scenarios are generated. A typical measure would involve worst case (MCO analysis), best case and likely. (This may be used to commit money in money markets et. Al.). 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 predefined.

Structural Liquidity

Structural liquidity is critical for an institution. Therefore, policies must be 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 bands. 1-14 days, 15-days to 1 month, 1 month to 2 months etc. is an example. This organisation is termed 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 is analysed. Regulators specify use of percentage of tolerance for gaps. Practical bankers use an absolute amount. Thus, as long as gap remains within tolerance, then it is deemed zero. Thus, the statement in the beginning that zero gap is impractical and not desired either. Banks funding or lending gaps may be very deliberate. 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.

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. For example, if a bank provides a 10 year housing loan, then it is has to locate 10 year assets to minimize market risk for that loan. Both traded and non-traded assets and liabilities carry market risk and any technique should address this. All products carry market risk and this needs to be addressed as well. It must be understood that all statistical techniques are forecasting algorithms based on history in some form or the other. There is no guarantee that history will repeat itself and new paths and patterns may emerge. Statistical techniques help make judgments. They are not replacements for flesh and blood managers. 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. Buckets may be determined carefully. Making buckets too small leaves a large number of buckets. Making them too large may hide some sensitivity issues. Especially in volatile buckets (1-90 days), definitions must be small and in larger buckets (3 years to 30 years), bucket size may be larger. As with liquidity, an absolute value of gap may be used to measure this risk.

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Duration Gap Duration gap measures sensitivity of portfolio to interest rate changes. Dollar duration is a measurement of drop in market value of (bank as) portfolio for a weighted average change of interest of 1%. Modified duration is a measure perfected by bond traders is a measure of sensitivity of market value of (bank as) portfolio to interest rate changes. Thus, in this analysis, banks transactions are mapped as zero coupon bonds and their market value determined using yield curves for discounting. Then duration is calculated for the same. However, it is to be noted that the usage of a yield curve may not be correct for some products. A more realistic discounting measure would be the products own interest rate. NII Sensitivity analysis Sensitivity of Net Interest Income to movement in interest rates may be determined by changing interest receivable and payable. 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 banks 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 predefined.

However, mapping of non-term products is slightly more complex. They have to be synthetically split into multiple zero coupon bonds. Splitting rules vary for each maturity bucket. BALM supports multiple concurrent bucketing schemes. Thus, for example, in scheme 1, savings bank may be split into 5% on 1-14 day bucket, 10% on 15-1 month, and 85% in over 30 years. In scheme 2, however, split may be 10% in 1day 1 month bucket and 90% in over 30 years. Derivation of these percentages to split by is outside the system. Models for determining this may be quite complex as these contain options and cash flows of these options have different valuation algorithms. These must be available to have evaluated options in the first place. Thus, problem reduces to determining cash flows emanating from embedded options, where no deliberate evaluation has been made, exemplified by savings bank. Here, historical behaviour of rate of change is assumed to be in a log-normal distribution and hence volatile portion determined. Non-volatile portion is determined by subtracting volatile portion from the total.

IV. 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 should address all issues concerning the bank, all policies should be clearly explained to all members of board, apart from ALCO and these must be documented. Proper revisions to this document, a quarterly review needs to be organized as well as parameters may be changing due to change in situations.

Understanding of complexities

III. A Model for implementation

For any risk measurement in finance, all complex instruments are reduced to simple instrument in an artificial manner, preserving market value and market risk. Then, simple instruments are analysed for risks.
The simplest financial instrument is a zero coupon bond.

Many people in a bank need to understand risk measurements and risk mitigation procedures. Measurement of risk is a fairly simple phenomenon and does go on regardless. Formalisation of understanding, especially at a top level, will be helpful as it would help in decision making.

Organization and culture

BALM implements all above functions by reducing banking transactions to a simple zero coupon bond. Mapping of term products to zero coupon bond is very straightforward. Maturity date is known and principal is expected back on the cash flow date. Interest however, is put into another item called interest receivable as another zero coupon bond as this is required for repricing effect on NII and interest bears zero interest rate.
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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 4

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 may not be available at all times in requisite format. It must be remembered that many data items are assumptions and gaps must be measured in perspective. There was a case of a manual branch of a bank that was closed for 6 months in a year due to inclement weather and was largely inaccessible. As data may not be obtained from this branch for 6 months, appropriate assumptions have to be made in any event. The argument is that for all other purposes, assumptions are being made. Sensible options need to be chosen and manual branch without computer was an example. However, in modern banking, it is mapping of models to zero coupon bonds that are an issue. Once again, arguments are that this should exist within the bank. Based on sophistication required, multiple models may be used to validate this conversion. This is strictly outside ALM framework but integrates into ALM framework.

Unrealistic goals

An ALCO secretary was seen desperately trying to tweak with parameters to show less gaps in liquidity reports. A zero gap is not practical. Returns are expected for taking risks. Banks assume market and credit risk and hence they make returns. ALCOs job is to correctly determine positions and put in place appropriate remedial measures using appropriate risks. It is not to show things as good when they are not. In any event, market risks and credit risks are not the only causes for failure, as evidenced by failures in the last decade.

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