Issues in Asset Liability Management - I Author(s): A. V. Rajwade Source: Economic and Political Weekly, Vol. 37, No.

5, Money, Banking and Finance (Feb. 2-8, 2002), pp. 378-379 Published by: Economic and Political Weekly Stable URL: http://www.jstor.org/stable/4411679 . Accessed: 06/04/2011 12:41
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in Asset Issues Liability Management

Thesubjectof asset liability managementis of relativelyrecent origin both internationallyand, more so, in India. This is the first of a series of articles which will discuss the differentissues involved,critically examine the maturitygap model, suggest alternatives,look at the principles of pricing deposits and advances and deal with connectedsubjects.
A V RAJWADE

liability management tively recent subject. Historically, supervisory concerns were more focused on credit risk than on interest rate risk. The latter became a matter of crucial importance only after the deregulation of bank interest rates in the US in the late 1970s; we in India followed suit in the 1990s. In the US, the biggest impact of deregulated interest rates was felt by the savings and loan, ie, housing finance, industry. The industryhad to be bailed out at a huge cost to the taxpayerrunninginto hundreds of billions of dollars. To be sure, the losses were much more than what they otherwise would have been because, in 1979, the US FederalReserve changed the way it implementedmonetarypolicy. Traditionally(and even now) it has targeted the overnight interbankrate,the so-called FederalFunds Rate, through open market operations. In 1979, in a bid to curb inflation, the Fed startedtargetingmoney supply ratherthan interest rates, resulting into very high and volatile - interest rates, an explosive mixture whose victims included the savings and loan industry. (The other major segment hit by the sky-high USD interest rates were the thirdworld countries which had raised huge LIBOR based loans in the 1970s to pay for the galloping oil bill: the 1980s debt crisis was the result.) But turningback to the savings and loan industry,fordecades,the interestthey could charge on housing loans, their principal activity, and pay on deposits, were regulated (wags used to refer to savings and loans bankersas 3-6-3 bankers:pay interest at 3 per cent on deposits, charge interest at 6 per cent on loans, and go to play golf at 3 PM!). When interest rates were deregulated in the US, the cost of funds went up sharply. To avoid making losses, savings andloans increased theirexposure to risky assets likejunk bonds, in a dramatic

terms concerns, Inasset of banksupervisoryis a rela

fashion. When major defaults occurred also of resultpartly because therecession ing from the high interestrates, a large segmentof the savingsandloan industry wentinsolventandultimately theUS cost like taxpayer something $ 500 bn.Indeed, in the savings and loan industry US is a in casestudy what happen can wheninterest ratesarederegulated theindustry and does not take steps to managerisks properly. The subjectof asset liabilitymanagement covers both interestrate risk and liquidityrisk.However,it is proposedto focus on the former.This is of crucial to importance all thosefinancialintermediarieslike banks,financialinstitutions, NBFCsandprimary dealers,whose prinis cipalsourceof earnings the net interest But too margin. others canbehit.Inarecent UK case, a centuries-old insurerhas life had to close down operations becauseit assured returns policy-holders to basedon the high interestratesof the 1970s- and is unableto meet the obligationsin the rate ruling,muchlower interest scenario. As faras banksareconcerned, Basle the Committeeon BankingSupervisionhas withthequestion interbeenconcerned of est rateriskfor severalyearsnow. It has withinthe purviewof its alreadybrought normsthetopicof intercapitaladequacy est rate risk in the tradingactivities of norms banks.While no capitaladequacy have so far been made applicable to the non-trading activitiesof the banking system (such as normaldepositsand advances), the Basle Committeehas come out with a report titled 'Principles the for Managementof InterestRate Risk' in is 1997.Thefullreport available September on the web site of the Bank for InternationalSettlements(www.bis.org). Indian Scenario In recent years in India, most of the interest rates have been deregulated; securities soldin auctions are government

and banks are also, with a few exceptions, free to determine the interest rates on deposits and advances. Historically, banks in India have not paid much attention to the topic of management of the interest rate mainly because all interest rates were regulated by the central bank. With the changing scenario, the topic assumes a great deal of importance as market determined interest rates inevitably lead to volatilityandhence interestraterisk.Again, with a large partof the securities portfolio now subject to 'markto market' valuation for compiling accounts, banks' bottom lines are vulnerable to changing interest rateson thisscoreas well, i e, over andabove the fluctuation in the net interest margin. It is manifest that the greater the capital intensiveness of a business, greater is the impact of interest rate changes on the bottom line. Amongst all businesses, banking is perhaps the most capital intensive since the gross value added through intermediation(or the net interest income) as a proportion of the capital employed is perhapsthe lowest- clearly an evidence of the extremely capital-intensive nature of banking. While rigorous data about the impact on the rupee book of Indian banks of interest rate changes are not available, the author knows of many banks having lost substantialamountson theirFCNR(B) portfolios through a lack of appreciation, identification and management of the interest rate risk. The impact on the far more complex rupee book is hardly likely to be significantly different. This apart,the Indianmutualfundsindustry has also been a major victim of mismanaging assets and liabilities, with the cost runningto well in excess of Rs 10,000 crore. Take the case of US 64 which, for all practical purposes, was perceived as an assured income scheme, and which is now in deep trouble. To my mind, the problem arose primarily because of significant investment in equities, on which obviously there are no assured returns! Quite apartfrom US 64, many banks, as trustees of assured returns on various schemes, have suffered losses totalling a few thousand crore in meeting their obligations. Unlike US 64, most such schemes were close-ended. But the problem was that the asset investment policy was not such as to earn the assured returnon the liabilities. For close-ended schemes, assured returns would be possible only if the entire money is invested in fixed income securities, and the duration of the portfolio is so kept as to coincide with the maturityof the scheme. But focusing on banks and financial institutions, their dependence on net interest margin for meeting their costs and

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earningprofitsis high as the following of the bankingsystem, with the average data evidence. of maturity the liabilitiesportfoliolonger (As Per Cent of TotalAssets) than that of the asset portfolio. dealersalso face a significant Primary Commercial Financial NBFCs of in amount riskas theyoftenborrow the Banks Institutions(1999(2000-2001)(2000-2001) 2000) interbank money marketfor investcall ment in datedgovernment securities.To Net Interest 6.5 income 2.84 1.60 Other 1.32 1.2 income 0.95 an extent,primary dealersare in a better 1.06 4.0 expenses 2.64 Operating position to take the risk, because their 1.52 1.49 3.7 Surplus is that gearing muchlowerthan of theother Source: Reporton Trend Progressof Banking financialintermediaries. and
in India2000-01, RBI.

total assets and liabilities), to prepare estimatesfor the bank as a whole. (2) ALM Organisation At thetopof theALMorganisation the is boardof directors whichhas finalresponIt decidethe for sibility thefunction. should riskmanagement andspecifylimits policy, for interestrate (andother)risks. The next tier of the ALM organisation is the Asset LiabilityCommittee (ALCO) which would be responsible ensuring for thatthepoliciesandlimitsset by theboard areimplemented. ALCOwouldconsistof senior executives of the bank, and also decide the businessstrategyon the assets andliabilityside,in particular rate interest mix desired pricing, maturity profile, of incremental assetsandliabilities, ALCO etc. shouldalso articulate bank'sviews on the theinterest movements devisethe rate and fundingmix. ALCOwouldbe assistedby a support groupfromthe bank'streasury. The management anotherspecial) (or committee theboardshouldoverseethe of of implementation the ALM system and review its functioning with a view to refiningit. (3) ALM Process As faras theinterest riskis concernrate income ed, it canaffectboththenetinterest fora givenperiod, alsotheeconomic(or as valueof a bank'sequity.To start 'market') with, interestrateriskis to be considered from the angle of the net interestincome by using maturitygaps in the following time bands(or buckets),of the assetsand in liabilitiesdueto be repriced eachband: (i) 1 to 28 days;(ii) 29 days to 3 months; (iii) over 3 monthsto 6 months;(iv) over 6 monthsto 1 year;(v) over 1 year to 3 (vi) years; over3 yearsto 5 years;(vii)over 5 years; and (viii) not sensitive. If, for anytimebucket,the maturity gap is positive,ie, ratesensitiveassets larger thanratesensitiveliabilities, mismatch the would help increasethe net interestincome in a risinginterestratescenarioand vice versa.Eachbankis required place to limits on the extent of gap in each time bucket.The guidelinesalso suggest that a proper transfer within pricemechanism the bankis an important of component an effective and efficient ALM system. The guidelinesalso prescribethe rules for classification of various liabilities andassetsin thedifferent timebuckets. In thenext article, wouldconsider issues I the classificaarisingfromthe recommended tion of assetsand liabilitiesinto different buckets.B31 maturity

the Clearly,protecting/improving net in- RBI Guidelines terestmarginin a changinginterestrate scenario asset The Reserve Bank of India came out through appropriate liability is for with its guidelines on Asset Liability management important them. Management Systemin BanksinFebruary 1999.Theseguidelinescovernotonly the Asset Liability Structures rate of Different Entities topicof interest riskbutalso liquidity risk and a few otherpricerisks.RBI has As faras thefinancialintermediaries issuedseparate ALMguidelines finanin for Indiaareconcerned, principal the ones are cial institutions (December 1999) and thecommercial the institu- NBFCs (June2001). All threeguidelines banks, financial dealers. interest are similar and the differencesare not The tions,andtheprimary rate risk arises from the mismatch in meaningful. maturities the assetsandthe liabilities. TheReserve of Bank'sguidelines banks for As far as the commercialbanks are issuedin February 1999wereto be implethe witheffectfromApril1, 1999.The concerned, particularly largerIndian mented publicsectorbanks,the principalsource guidelines recognisethatsomebanksmay of mismatchis their holdings of fixed have alreadyin place more sophisticated incomesecurities partof theirstatutory systems,whileothersmaynothaveproper as The liquidity portfolio. bulkof the liabili- datato cover 100 per cent assets and lities of thecommercial banksarerelatively abilities.The objectivethereforeis that, short term, while the portfolioof fixed to startwith, at least 60 per cent of the incomesecurities,whichformsa signifi- assets and liabilitiesshould be covered, cantproportion theirtotalassets,often but 100percentcoverageis mandatory of in has a much longerduration maturity. due course. While the guidelines take of Thismismatch leadtosubstantial can losses maturity gaps in differenttime bandsor on the fixed incomeportfoliowheninter- timebuckets thestarting as point,theyalso est rates go up. The Reserve Bank has envisage that in course of time more a normforthe sophisticatedmeasurement prescribed capital adequacy systems like and holding in governmentsecurities as a duration gap, simulation valueat risk cushionagainstthe interestraterisk.But analysis would be introduced. this is verynominal.Again,it is not as if The guidelines specify the following thatportfolio aloneis thesourceof therisk. threefoundations asset liability manof On the liability side, the fixed deposit agement is portfolio alsoa sourceof risk,quiteapart fromthe riskof depositorsshiftingfrom (1) ALM Information System savings bank accountsto fixed deposits wheninterest ratesarehigh,further The promptavailabilityof assets and adding to costs. Banksalso face a risk from the liabilities data, including in particular options embeddedin the fixed deposit residual maturities,as also off-balance the like portfoliothrough freedomto the de- transactions interestrate swaps, are for encashment. While thekey to aneffectiveALMstrategy. This positors premature contractually nobodycan force a bankto wouldpresenta majorchallengeto banks make premature payment of the fixed in India which may not be optimally deposit,in practicefew bankscan resist computerised. Again,thedatafromall the such requests. offices shouldbe electronically collatedat As forthefinancial the institutions, bulk a centralplace. Since it will taketime for of their liabilities are bullet repayment many banks to put in place a suitable an bonds,while mostof the assetsarein the system,the guidelinesadvocated ABC formof instalment i loans. In a approach, e, using data from a limited repayment way, therefore,the financialinstitutions numberof branches(but which account haveanexactlyoppositemismatch that for a significantproportion the bank's to of
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