Project Report
on
Banks
_______________________________________________________________________
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Asset and Liability Management
The project report in the Area of Specialization – Finance is submitted in March 2011 to
K. J. Somaiya Institute of Management Studies & Research, Mumbai in partial
fulfillment of the requirement for the award of the degree of Master of Management
Studies (M.M.S) affiliated to the University of Mumbai.
Submitted to
By
Saikumar.M
Roll No: 56
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Asset and Liability Management
CERTIFICATE
This is to certify that project entitled “Asset and Liability Management in Banks” is
Prof K.S.Ranjani
(Project Guide)
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Asset and Liability Management
ACKNOWLEDGEMENT
This is to express my earnest gratitude and extreme joy at being bestowed with an
impossible to thank all the people who have helped me in completion of project, but I
would avail this opportunity to express my profound gratitude and indebtness to the
following people.
I am extremely grateful to my project guide and co-coordinator Prof K.S.Ranjani who has
report better. Credit also goes to my friends whose constant encouragement kept me in
good stead. Lastly without fail I would thank all my faculties for providing all explicit
Saikumar.M
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Asset and Liability Management
Executive Summary
Asset and Liability management is the co-ordination of the asset and liability portfolios in
order to maximize bank profitability. Its objectives are planning to meet needs for
liquidity, matching the maturities and rate structures of assets and liabilities to limit their
exposure to interest rate risk and maximizing the bank’s spread between interest costs
management and what are the various strategies which are available to do the same. Also
the report would cover the purposes of liquidity and its various types, which are the risks
involved in it and what effect does it have on the bank’s assets and liabilities. What is the
nature and objectives of liability management and how a bank’s liquidity needs are
estimated. The report will cover which are the various types of funding instruments for
the bank. In this context the concept of yields on fixed income securities
and the relationship between yield and price will also be ascertained and the concept of
yield curve will also be explained. This will also include how yield curves can be used to
anticipate changes in market rates and how yield spreads can be used to choose between
securities of like maturity. The various investment instruments for a bank like the various
types of money market instruments and the risks involved in the same.
The report will also cover the nature of the primary and secondary markets in which the
securities owned by the banks are traded and the role of underwriters and dealers in
primary and secondary securities markets. The types of market information that banks
can obtain from the external sources and through internal market analysis tools. Also the
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Asset and Liability Management
purposes of liquidity account and the characteristics of the assets held by it will also be
covered. The investment portfolio policy of banks and the various strategies and
procedures for establishing and reviewing investment portfolio policy, the types of
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Asset and Liability Management
Table of Contents
Particulars Page No
1 What is Asset Liability Management (ALM) 7
2 Asset and Liability Management Strategy 10
3 Strategic Approaches to ALM
Spread Management 12
Gap Management 13
Interest Sensitivity Analysis 17
4 Liquidity 18
5 Liquidity Risk Management (LRM) 21
Trends in LRM 22
Best Practices in marketing Liquidity Risk 25
Other Best practices 36
6 Liability Management 39
Objectives 40
Benefits 41
Risks involved 42
7 Yield Curve 43
Types of Yield Curve 44
Credit Spread 47
Price Yield Relationship 49
Calculating Yield to maturity 52
Calculating Yield to call and put 56
8 Indian Money Market 58
Money Market Instruments 59
9 Primary and Secondary Markets 62
Underwriters in primary markets 63
1 Asset management and Liquidity Account 64
0
1 Investment Portfolio Policy 68
1
Elements of Investment Policy 69
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Asset and Liability Management
Asset/ liability management (ALM) is a tool that enables bank managements’ to take
business decisions in a more informed framework. The ALM function informs the
manager what the current market risk profile of the bank is and the impact that various
alternative business decisions would have on the future risk profile. The manager can
then choose the best course of action depending on his board's risk appetite.
Consider for example, a situation where the chief of a bank’s retail deposit
mobilization function wants to know the kind of deposits that the branches should be
told to encourage. To answer this question correctly he would need to know inter alia
the existing cash flow profile of the bank. Let us assume that the structure of the
existing assets and liabilities of the bank are such that at the aggregate the maturity of
assets is longer than maturity of liabilities. This would expose the bank to interest rate
risk (if interest rates were to increase it would adversely affect the banks net interest
income). In order to reduce the risk the bank would have to either reduce the average
increase the average maturity of its assets, perhaps by reducing its dependence on
call/money market funds. Thus, given the above information on the existing risk
profile of the bank, the retail deposits chief knows that the bank can reduce its future
may offer increased rates on long-term deposits and/or decreasing rates on the shorter
term deposits.
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Asset and Liability Management
The above example illustrates how correct business decision making can be added by
the interest rate risk related information. The real world of banking is of course more
complicated. The risk related information is just one of many pieces of information
required by a manager to take decisions. In the above example itself the retail deposits
chief would also have considered a host of other factors like competitive pressures,
demand and supply factors, impact of the decision on the banks retail lending
products, etc before taking a final decision. The important thing, however, is that ALM
with an eye on the risks that the bank is exposed to. ALM is thus a comprehensive and
dynamic framework for measuring, monitoring and managing the market risks, ie
liquidity interest and exchange rate risks of a bank. It has to be closely integrated with
the bank’s business strategy as this affects the future risk profile of the bank.
philosophy, which clearly specifies the risk policies and tolerance limits.
ALM is a term whose meaning has evolved. It is used in slightly different ways in
different contexts. ALM was pioneered by financial institutions, but corporations now
Traditionally, banks and insurance companies used accrual accounting for essentially all
their assets and liabilities. They would take on liabilities, such as deposits, life insurance
policies or annuities. They would invest the proceeds from these liabilities in assets such
as loans, bonds or real estate. All assets and liabilities were held at book value. Doing so
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Asset and Liability Management
disguised possible risks arising from how the assets and liabilities were structured.
Some banks had the traditional deposit base and were also capable of achieving
substantial growth rates in deposits by active deposit mobilization drive using their
extensive branch network. For such banks the major concern was how to expand the
assets securely and profitably. Credit was thus the major key decision area and the
liquidity management. The management strategy in such banks was thus more biased
Some banks on the other hand were unable to achieve retail deposit growth rates since
they did not have a wide branch network. But these banks possessed superior asset
management skills and hence could fund assets by relying on the wholesale markets
using Call money, CD’s Bill Rediscounting etc. Deregulation of interest rates coupled
with reforms in the money market introduced by the reserve bank provided these banks
with the opportunity to compete with funds from the wholesale market using the pricing
strategy to achieve the desired volume, mix and cost. So under the Liability management
approach, banks primarily sought to achieve maturities and volumes of funds by flexibly
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Asset and Liability Management
ALM STRATEGY
As interest rated in both the liability and the asset side were deregulated, interest rates in
various market segments such as call money, CD’s and the retail deposit rates turned out
to be variable over a period of time due to competition and the need to keep the bank
interest rates in alignment with market rates. Consequently the need to adopt a
comprehensive Asset- liability strategy emerged, the key objectives of which were as
under.
The volume, mix and cost/return of both liabilities and assets need to be planned and
monitored in order to achieve the bank’s short and long term goals.
Management control would comprehensively embrace all the business segments like
coordinated and internally consistent so that the spread between the bank’s earnings
Suitable pricing mechanism covering all products like credit, payments, custodial
financial advisory services should be put in place to cover all costs and risks.
Gap Management: This focuses on identifying and matching rate sensitive assets
and liabilities to achieve maximum profits over the course of interest rate cycles.
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Asset and Liability Management
Interest Sensitivity Analysis: This focuses on improving interest spread by testing the
effects of possible changes in the rates, volume, and mix of assets and liabilities,
These strategies attempt to closely co-ordinate bank assets and liability management so
that bank’s earnings are less vulnerable to changes in interest rates. We will now look at
Spread Management
This focuses on maintaining an adequate spread between a bank’s interest rate exposure
on liabilities and its interest rate income on assets to ensure an acceptable profit margin
regardless of interest rate fluctuations. Thus spread management aims to reduce the
bank’s exposure to cyclical rates and to stabilize earnings over the long term and in order
to achieve this banks must manage the maturity, rate structure and risks in iots portfolios
so that assets and liabilities are more or less affected equally by interest rate cycles.
Maturities on assets and liabilities are either matched or unmatched. If they are matched
then the bank knows what it must pay for deposits and borrowed funds and what it will
earn on loans and investments. If maturities are unmatched then assets and liabilities will
mature at different times and in this case management cannot lock in a spread because
funds must be reinvested as assets mature and funds must be borrowed as liabilities
Co-coordinating rate structure among assets and liabilities is a second most important
aspect of spread management because rate structure and maturity combined determine
interest sensitivity in assets and liabilities. For rate structure, the rates paid and earned on
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Asset and Liability Management
fixed- rate assets and liabilities are not sensitive to changes in market rates because their
rates are fixed for the term of the instrument’s maturity. Variable rate assets and
liabilities are interest sensitive because their earnings fluctuate with changing market
conditions.
Risk of default is the third aspect of assets and liabilities that must be coordinated in
spread management. A bank assumes greater risk of default in its asset portfolios than it
can in its liability portfolios since the depositor’s funds need to be protected. Therefore
balancing the default risk against the benefit of probable returns by assuming some risk to
Because it is difficult to forecast future rate and yield changes accurately, many banks try
to match their rate sensitive assets to their rate sensitive liabilities. This approach will
lead to controlled but steady growth and a gradual increase in average profitability.
Gap Management
Variable: Interest bearing assets and liabilities whose rates fluctuate with general
Fixed: Interest bearing assets and liabilities with a relatively fixed rate over an
Matched: Specific sources and uses of funds in equal amounts that have
predetermined maturities.
By defenition, gap is the amount by which the rate sensitive assets exceed the rate
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Asset and Liability Management
sensitive liabilities. The gap indicates the dollar amount of funds available to fund the
variable rate assets with variable rate liabilbities. Gapa measurement allows the
management to evaluate the impact the various interest rate changed will have on
earnings.
The objective of gap management is to identify fund imbalances. For example, If rates
are declining and the banks have an excess of variable rate assts over fixed rate liabilities
the bank’s rate will narrow and interest rate margin will be reduced. On the other hand if
rates are increasing and variable rate assets exceed fixed rate liabilities the bank’s rate
The gap is really a measurement of the bank’s balance sheet sensitivity to changes in the
interest rates ,expressed as a ratio of the rate sensitive assets to rate sensitive liabilities.
The greatest stability occurs when rate sensitive assets equal rate sensitive liabilities or a
ratio of 1.
The matched gap in the fig illustrates this position. In general, with this ratio the bank’s
earnings should remain the same regardless of the interest rate changes because equal
Then the sensitivity ratio is greater than 1, the bank has a positive gap, or is asset
sensitive. This position is illustrated by the second gap in exhibit. If interest rates rise, the
bank will benefit as more assets than liabilities are repriced at higher rates. Conversely, if
rates fall the bank’s margin will be negatively affected as more assets than liabilities will
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Asset and Liability Management
Assets
Matched Gap
Matched Matched
Positive Gap
Matched Matched
Negative Gap
Matched Matched
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Asset and Liability Management
When the sensitivity ratio is less than 1, the bank has a negative gap or is liability
sensitive. This position is illustrated in the figure’s final gap illustration. If interest rates
fall the bank will be benefited as more assets than liabilities will be repriced at lower
rates. Conversely, if interest rates rise the bank’s margin will be negatively affected as
more assets than liabilities will be repriced at lower rates. The impact on earnings from a
rate change with a particular sensitivity position are generalizations and that a change in
asset/liability mix and interest spread may affect the bank’s margin either positively or
negatively, regardless of the gap position and the change in interest rates.
For example, assume that the bank is in matched position holding variable rate assets (90
day prime rate loans) and variable rate liabilities (90 day CDs) with an interest spread of
2%. Now assume that the general level of rates rise by 1%. But because business credit
demand is up, banks are borrowing more money to finance loan growth. Due to this the
CD rates have risen to 9.5% thereby reducing the interest spread to 1.5%. Although the
bank is in matched position and identical amounts of assets and liabilities are repriced the
In gap management, the absolute size of the gap must be controlled to optimize the fixed
Similarly stated, the gap position must be managed to expand and contract with rate cycle
phases.
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Asset and Liability Management
testing the effects of changes in rates, volume, and mix of assets and liabilities given
alternative movements in interest rates. In this analysis, the bank plans from a given point
in time and projects possible changes in its income statement that might result if changes
are made in the balance sheet. Such changes are then tested against scenarios of rising
rates and falling rates for periods ranging from two weeks to one year.
The analysis begins by separating the bank’s balance sheet into fixed rate and variable
rate components. The interest rate and margin are identified in the current year. The next
step lists the various assumptions that involve the rate, mix, and volume of the bank’s
portfolios- for example, projected increases in the volume of loans, consumer time
deposits, and larger CD’s, as well the current rates on these instruments. The remaining
key assumptions reflect the possible alternative directions in which the rates may move.
The bank then tests the effect of assumed changes in the volume and composition of its
portfolios against both interest rate scenarios (rising and falling rates) to determine their
However if the bank’s assets and liabilities are unmatched, the bank’s earnings can be
protected or improved by planning courses of action in advance for periods of rising and
falling rates.
Hedging with futures trading is a final strategy that can be used to protect against
exposure to interest rate risk if the bank’s interest sensitive assets and liabilities are
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Asset and Liability Management
unmatched. Banks can use futures contracts as tools of ALM by selling futures ( a short
hedge) or buying futures (a long hedge). If the bank is in an unmatched position in which
the interest sensitive assets are funded by fixed rate liabilities, it makes a long hedge. If
the position is one of fixed rate assets funded by interest sensitive liabilities the bank
makes a short hedge. The ability to use hedging effectively to offset risk in an unmatched
position require that the future course of interest rate levels be predicted accurately.
It is the ease with which you can turn your investment quickly into cash, at or near the
current market price. Some securities, such as mutual funds, offer liquidity by allowing
investors to redeem their securities (return them to the issuer) on short notice. For non-
redeemable securities, liquidity will depend on the owner's ability to sell the securities to
other investors in the open market. Listing on a stock exchange may help, but does not
guarantee liquidity. With some securities, law or contract from reselling the securities for
months or even years may restrict investors, or they may find that there is no market for
increasingly use banks as a means to access the payments system and, consequently,
maintain minimal transaction balances. This has resulted in a situation where all banks
are facing high loan demand while their core deposits continue to erode. Most
multinational and regional banks turned to wholesale funding sources to fund asset
growth years ago; we are now seeing small banks being forced to turn to alternative
funding sources, such as subordinated debt, Government Home Loan, Bank loans, and
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Asset and Liability Management
Liquidity Risk
Liquidity risk is the potential that an institution will be unable to meet its obligations as
they come due. This is generally because the bank cannot liquidate assets or obtain
adequate funding (funding liquidity risk) or that it cannot easily unwind or offset large
exposures without significantly lowering market prices because of thinly traded securities
markets or market disruptions (market liquidity risk). While the following is not all
inclusive, it does present several criteria can serve as a guide to determine the level of
inherent liquidity risk in an institution: The composition, size, and availability of asset-
based liquidity sources in relation to the institution’s liquidity structure and liquidity
needs should be gauged. Factors to consider include the levels of money market assets
securitization and asset sales activities. Thus, a bank that utilizes predominantly short-
term liabilities for funding will generally require more asset-based liquidity. Conversely,
a bank utilizing predominantly long-term liabilities, such as core deposits, for funding
generally will require lower asset-based liquidity. The nature, volatility, and maturity
structure of funding liabilities given the institution’s core business (for example, whether
versus retail funding sources, and large funding concentrations, both by type of
instrument and by funding source. Bank management must make sure that the liability
structure makes sense given the nature of the assets generated by the core business.
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Asset and Liability Management
structures supported by a stable and long-term liability structure. Conversely, a wholesale
structure. This arrangement is considered adequate, since the asset and liability roll-off
The portion of funding sources with common exposures. Bankers should look at their
Many bankers have learned the hard way over the years that their funds providers were
not as diversified as they thought. It is entirely possible to utilize funds providers located
all over the country that have a common exposure in such areas as sub prime lending or
drying up of funding from traditional providers, which can cause large-scale funding
problems. Funding gap assessment is very important, especially the institution’s short-
term exposures. Factors to assess include projected funding needs, assessment of bank’s
ability to cover any potential funding gaps at reasonable pricing, and trends in asset
quality. All funding analysis techniques assume that assets pay when due. Banks
experiencing asset quality problems must revise their funding analysis to embody a more
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Asset and Liability Management
realistic set of assumptions about asset roll- off. The composition of the off-balance sheet
portfolio and its probable impact on funding must be evaluated. Factors that must be
assessed include off-balance sheet liability levels, composition of the off-balance sheet
liabilities, and the off-balance sheet monitoring program. The institution’s funding
Factors to consider include cash flows, secondary liquidity of the securities portfolio,
A factor that is increasingly important is the rating services’ view of the institution. The
two factors to assess are current ratings and rating agency perspective on the condition of
the institution and rating trends. A detailed assessment of the institution’s contingency
Factors to evaluate include the monitoring and metrics program, a viability assessment of
the contingency plan in light of the abilities of management, an assessment of policy and
strategic goals, and a review of the structure and responsibilities of the crisis management
team.
increasing volatility of these funding sources. Managers who fail to develop an effective
strategy for maintaining adequate liquidity may find that, at best, their business plans are
adversely affected by funding difficulties, and at worst, their bank’s ongoing viability is
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Asset and Liability Management
threatened. Recent volatility in the wholesale funding markets has highlighted both the
importance of sound liquidity risk management practices and the fact that financial
institutions can and have experienced liquidity problems even during good economic
times. As a result, bank management’s ability to adequately meet daily and emergency
liquidity needs while controlling liquidity risk through risk identification, monitoring, and
controls is receiving increasingly intense regulatory scrutiny. To meet the new demands
Funding pools
Many multinational banks are moving away from back up lines of credit as their principle
commitment fee costs, material adverse change clauses, and a potentially adverse
While many banks still maintain these lines, they no longer rely on them as their principle
source of back up liquidity (merely to meet the rating agencies’ requirements). These
banks now rely principally on segregated pools of liquid assets, generally, marketable
securities. Two keys to making this approach work include are to fill them with
investment grade securities to preclude the possibility that they could not be readily sold
in adverse markets and to avoid the use of securities from thinly traded markets that
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Asset and Liability Management
Funding strategies
Banks are revising their funding strategies to avoid funding concentrations. Most
banking experts agree that excessive funding concentrations severely reduce the bank’s
ability to survive a liquidity crisis. Many banks are taking advantage of the good
economic times to diversify their funding sources. While most banks have developed a
contingency funding plan, the vast majority require some level of enhancement, including
scenarios. Many banks do not have predefined triggers to automatically implement their
contingency plan, and management should develop critical warning signals that would be
used as a benchmark during periodic liquidity reviews. In some cases, banks increasingly
are stress testing their funding plans, using various interest rate shocks and adverse
economic and competitive scenarios to ascertain their impact on both the funding
portfolio and market access. At a minimum, the funding plans are generally tested with
an interest rate shock simulation incorporating a drop or gain of at least 200 basis points.
On the horizon, banks are seeking ways to link their liquidity risk models with their
market risk models. The goal is to stress test their portfolios, load the resulting data into
their liquidity models, and see what will happen to their funding positions.
Communication
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Asset and Liability Management
Some banks are working to improve the communication lines between the treasury
function and back-office operational areas. At present, the treasury area relies on informal
lines of communication to keep it updated on operational events that could affect funding.
As a result, the treasury area is frequently unaware of a disruptive event, such as a wire
transfer failure or the need to fund a large loan commitment draw down, until it is either
too late or very costly to cover the resulting funding shortfall. Bank management is
paying more attention to investor relations than ever before. This is because dependence
on wholesale funding sources has resulted in the growing importance of credit risk in the
credit risk and will terminate a funding relationship at the slightest hint of developing
credit problems at an institution. This has forced institutions to increase their attention to
Reporting systems
Reporting systems are not as effective as they could be in determining the funding
and then develop a guideline for a level of funding to be held against off-balance sheet
commitments. Unfortunately, they seldom, it ever look at the guideline again. As the
bank’s strategic objectives change and new products are offered, the level of off-balance
sheet liabilities tends to grow while the level of funding does not, since the bank’s
reporting process is not measuring the true level of liabilities. This lack of review,
coupled with the informal lines of communication between treasury and the operating
areas of the bank, has frequently resulted in costly funding mistakes. Many banks have
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Asset and Liability Management
realized this and are developing better off-balance sheet reporting systems. In addition,
many institutions have a tendency to ratchet down their report generation during good
economic times, either reducing the level of information contained in the report or
discontinuing some reports altogether. This practice appears acceptable as long as the
risk. Banks should realize, however, that to manage liquidity risk during adverse
needed. Therefore, policies should be in place to ratchet up the reporting process during
risks depends upon the maintenance of an active ALCO structure that has responsibility
for developing and maintaining appropriate risk management policies and procedures,
MIS reporting, limits, and oversight programs. While the size and organizational
structure of the ALCO varies between banks, there appears to be a trend developing to
liquidity risk through one central body. Proponents of this structure argue that the
principal benefit of a single committee is greater efficiency, since many of the individuals
serving on the subcommittees also serve on the central committee. One streamlined
committee sharply reduces costly duplication of time and effort while making the
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Asset and Liability Management
Best Practices for Managing Liquidity Risk
Recent volatility in the wholesale funding markets has served to highlight the importance
of sound liquidity risk management practices and reinforce the lesson that those banks
with well- developed risk management functions are better positioned to respond to new
funding challenges. The banking industry has developed many innovative solutions in
response to these challenges, some of which are presented here. Because banks vary
widely in their funding needs, the composition of their funding, the competitive
environment in which they operate, and their appetite for risk, there is no one set of
universally applicable methods for managing liquidity risk. While there is little
Strategic Direction
Bank management, generally through ALCO, must articulate the overall strategic
direction of the bank’s funding strategy by determining what mix of assets and liabilities
will be utilized to maintain liquidity. This strategy should address the inherent liquidity
risks, which are generated by the institution’s core businesses. For instance, if the bank
has major positions in global capital markets, then liquidity should be managed to lessen
the impact of sudden changes in global markets. Or if the bank funds commercial loans
with core deposits, then liquidity should be managed to reduce the impact of a decline in
asset quality or a runoff of core deposits. This strategy must be documented through a
comprehensive set of policies and procedures and communicated throughout the bank.
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Asset and Liability Management
Integration
asset and liability management policy should clearly define the role of liquid assets along
with setting clear targets and limits. In the past, asset/liability management’s goal was
This resulted in situations where asset and liability profiles structured for maximum
While the struggle between maximizing profitability and providing adequate liquidity
continues to this day, the best ALCO groups have realized that liquidity management
must be integral to avoid the steep costs associated with having to rapidly reconfigure the
Some of the greatest changes in risk management have occurred in the integration area.
now integrated into the day-to-day decision-making process of core business line
managers. This is frequently done through the use of loan growth and balance sheet
targets that are “pushed down” to business line managers. Some banks achieve this goal
through the use of a transfer pricing system - giving “liquidity-generating business lines”
an internal earnings credit while charging “liquidity-using business lines cost centers for
Measurement Systems
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Asset and Liability Management
Most banking experts agree that maintaining an appropriate system of metrics is the
linchpin upon which the liquidity risk management framework rests. If they are to
successfully manage their liquidity position, management needs a set of metrics with
position limits and benchmarks to quickly ascertain the bank’s true liquidity position,
ascertain trends as they develop, and provide the basis for projecting possible funding
scenarios rapidly and accurately. In addition, the bank should establish appropriate
benchmarks and limits for each liquidity measure. The varied funding needs of
institutions preclude the use of one universal set of metrics. As a result, banks frequently
use a combination of stock and flow liquidity measures or have gone to exclusive reliance
on models. Stock measures look at the dollar levels of either assets or liabilities on the
balance sheet to determine whether or not these levels are adequate to meet projected
needs. Flow measures use cash inflows and outflows to determine a net cash position and
any resultant surplus or deficit levels of funding. Models are built utilizing hypothetical
Balance-sheet-based measures are generally best suited to smaller institutions which fund
their business lines, generally loans, with core deposits. These banks generally develop
their measurement system and their corresponding benchmarks and limits based on either
selected peer group analysis or on studies of historical liquidity needs over time. In
addition, most of these banks utilize flow measures to determine their net cash position.
While this combination works well for smaller banks, regional and global institutions that
have significant trading operations and are heavily reliant on purchased funding find that
stock and flow measures are no longer adequate to meet their needs. As a result, these
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Asset and Liability Management
banks have either developed or have purchased model-based measurement systems to
Α . Cash Capital: Under this scenario, the model assumes that the bank is unable to
secure any outside funding. The model is designed to indicate how long the bank can
continue to meet its short-term funding obligations through asset sales. The model
calculates this by assessing the marketability of all bank assets and applying suitable
discounts to each. Once the discounted value of the assets is found, management will set
its benchmarks and limits. This model usually has a general limit, which is frequently
expressed in terms of a management set limit on the percentage of the discounted value
of the bank’s assets to total short-term funding. This general limit is then broken down
Β . Liquidity Barometers: This model calculates the length of time an institution can
survive by liquidating its balance sheet using just two assumptions - that the bank
continues to operate under normal operating conditions or that the bank has suffered a
Monitoring
Banks must be able to track and evaluate their current and anticipated liquidity position
and trend development, that enables management to monitor and confirm that compliance
is within approved funding targets and, if not, to pinpoint the variances. The most
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Asset and Liability Management
successful banks create objective targets for each liquidity measure, which often have
multi-level trigger points, to maximize their liquidity position. Because banks vary
widely in their funding needs, no one set of universally applicable liquidity measures or
incremental reporting, which monitors liquidity through a series of basic liquidity reports
during stable funding periods but ratchets up both the frequency and detail included in
reports produced during periods of liquidity stress. This type of reporting provides
without the delay involved in developing new reports. The key to any incremental
reporting program’s success is making sure that the incremental reporting structure is
such factors as the reliance on wholesale funding, off-balance sheet commitments, the
considered a sound practice to periodically audit the monitoring process to confirm the
adequacy and accuracy of the system as well as compliance with approved funding level
guidelines.
Banks operate in a dynamic funding market. As a result, both the bank’s balance sheet
and market access trends should be periodically evaluated for emerging patterns that
could adversely affect liquidity, and the bank should develop strategies to manage these
cash flows on both the asset and liability sides of the balance sheet, as well as off-balance
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Asset and Liability Management
sheet items. Experience indicates that off-balance sheet funding requirements, such as
loan commitments, are not incorporated into these periodic cash flow analyses.Therefore,
should be run to ensure that naturally occurring contingent liabilities will not exert
unexpected strains on the funding process at some point in the future. Part of any balance
sheet analysis is a review of future funding needs. As part of this assessment process, the
best banks have expanded the scope of their stress testing efforts from their contingency
planning to their funding profile. They run a number of scenarios to establish that they
will still be able to meet their funding needs at reasonable pricing levels in a variety of
economic conditions. The results of these stress tests should be reviewed by ALCO, and
any weaknesses found should result in changes in balance sheet strategies as well as
amendments to the bank’s funding policy. Because many banks are becoming more
funding sources as being both profitable and managed in a safe and sound manner. Thus,
counterparty/investor name acceptance in the money markets for any hints of resistance
through a periodic monitoring program. While these monitoring programs vary, nearly all
Decreased renewal rates for institution’s time deposit products (CDs, etc.).
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Asset and Liability Management
any weaknesses detected are promptly brought to management’s attention. All too often,
there are large time lapses between when market weaknesses have been detected and
when management is made aware of them. Finally, any balance sheet analysis should
since the industry trend is away from concentrations. Many banking experts believe that
Banks should have a formal contingency plan of policies and procedures to use as a
blueprint in the event the bank is unable to fund some or all of its activities in a timely
manner and at a reasonable cost. Industry experts generally agree that these crises tend to
develop very rapidly. Their onset is no longer measured in days but rather hours. The
former funding manager at one of these unfortunate banks once told the author that the
only good news on the day the funding crisis broke was that they had secured all of the
funding necessary to meet their daily position in the morning, since no one would sell
them funds in the afternoon. A comprehensive contingency funding plan can provide a
useful framework for meeting both temporary and long-range liquidity disruptions. A
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Asset and Liability Management
good plan should emphasize a reliable but flexible administrative structure, realistic
action plans, ongoing communications at all levels, and a set of metrics backed by
requirements ensures the availability of timely reports for rapid decision-making. The
Implementation
There is some diversity within the industry on how to implement the contingency plan.
implement the plan, while others rely on a set of critical warning signals that require
senior management to review the situation and decide whether to implement it. To assist
banks in developing their liquidity crisis warning signal criteria, the following list of the
reporting dates).
Customers start to cash in CDs and other time deposit products prior to maturity.
The bank begins to be closed out of some markets and is increasingly being
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Asset and Liability Management
Counterparty resistance develops to bank off-balance sheet products.
Policy and strategy considerations. Funding policies and strategies should be in place to
deal with various issues in a consistent manner during a liquidity crisis. Some of these
issues include:
The formation of a crisis management team is vital to the success of any contingency
funding plan. Experience has shown that a team of highly skilled staff members is
necessary to quickly assess the evolving situation, rapidly decide a course of action,
implement the actions, monitor the situation, and take corrective actions as necessary. It
is also imperative that senior management assumes an active role in this crisis
management team, starting with the careful evaluation of potential team members. Other
committee.
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Asset and Liability Management
Specify both under what condition(s) a liquidity crisis exists and what the
applicable).
Specify the corporate communication channels and how information will flow to
risks associated with a liquidity crisis. Some of the risk management procedures
More frequent meetings of the ALCO committee to ensure that all funding
strategies are being executed in an orderly and timely manner, that the situation is
being closely monitored, and that senior management and the board of directors
Reporting considerations:
Contingency plans should have good liquidity metrics and MIS support to ensure that
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Asset and Liability Management
mentioned earlier, metrics distribution should be on an incremental reporting basis.
Under incremental reporting, guidelines are set that mandate the frequency of metrics
reporting. In general, the deeper the crisis, the more frequent the distribution of metrics.
The bank should have a good estimated flow of funds time line for the liquidation of
various portions of its balance sheet. It should be emphasized that these estimates should
be realistic and based on tangible research. Remember, one of a bank examiner’s favorite
questions is, “How do you know you can obtain that level of funding from this balance
There should be a realistic analysis of cash inflows, cash outflows, and funds
availability at various time intervals (commonly 7, 10, 15, 30, 45, 60 and 90 days).
Generally, well-written plans will specify a sequence for the timely liquidation of
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Asset and Liability Management
Generally, it is considered a best practice to periodically test the back-up lines of
credit as part of the contingency plan. Having said that, there is a caution to observe.
Given the credit risk sensitivity of the money markets, many banks are reluctant to
test their lines for fear of inadvertently sending an adverse message to the inter-bank
markets. As a general rule of thumb, only banks with ample market access should
In many banks, the liquidity risk management systems have no provision for formally
the historical funding patterns of various types of off-balance sheet items. Incorporating
enhances the accuracy of funding projections, while assuring management that naturally
occurring contingent liabilities will not strain the funding process. A second best practice
is to establish formal lines of communication between the operational areas and the
treasury area to alert the funding area to any funding requirements caused by balance
sheet commitments.
Funds Management
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Asset and Liability Management
While many retail funded banks still rely on deposits and capital as their primary funding
source, most regional and multinational banks long ago outstripped these funding
sources, forcing them to rely heavily on purchased funds. Today, the industry is moving
away from exclusively managing the liability side of the balance sheet toward managing
both the asset and liability sides for maximum effectiveness. Banks are actively engaged
in managing assets through securitization of the loan book, loan sales, various asset
finance options (equities, governments, etc.), and liabilities through FHLB borrowings,
brokers notes, retail CDs, callable CDs, and subordinated debt. The selection and
maintenance of a diversified group of funding sources for both the liability and asset
sides of the balance sheet, as well as the establishment and maintenance of relationships
with liability holders, rating agencies, correspondents, and investors, is a complex and
ongoing process. Other factors that must be considered in funding source selection
include integration with the bank’s interest rate sensitivity, risk appetite, profit planning,
diversification, and capital management objectives. When reviewing a bank that is using
questions:
There should be a wide diversity of sources including, but not limited to, private
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Asset and Liability Management
Β . What types of funding instruments are offered by the bank?
demand and time deposits, Fed funds, TT&L note option, CDs, bankers acceptances,
Does the bank have a history of funding diversification and funding instrument
innovation?
Ζ . What is the bank’s maturity pattern for funding instruments? Staggered maturity
patterns, floating rate borrowings, and rollovers should be utilized as much as possible.
As a bank becomes more reliant on third-party funding, many banking experts consider it
a best practice to have an on-going program of funds provider and rating agency
relations. It is vital that the bank be perceived by third parties as being profitable and well
run. Issues that need to be addressed in assessing the bank’s relationship management
efforts include:
Α . Does the bank have a proactive program in dealing with issues involving rating
agencies?
There should be evidence of an active rating agency relations program. Rating agencies
revise debt ratings more quickly today than ever before, and banks need ongoing
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Asset and Liability Management
relationships with the rating agencies so that they can make their views on any adverse
developments known. This ability to discuss situations informally with the rating
Third-party funding providers, both domestic and foreign, are much more credit sensitive
to any sign of bank weakness than ever before. Active funds provider relations programs
have proven effective in forestalling “funder flight” caused by some temporary adverse
Χ . Does the bank know which funding sources are the most credit sensitive?
The bank must know who its most sensitive funding sources are and structure its
LIABILITY MANAGEMENT
In the broadest sense liability management involves the planning and co-ordination of all
the bank’s sources of funds in order to maintain liquidity, profitability and safety to
maintain long-term growth. Effective liability management ensures that funds are
available over the short term to meet reserve requirements and to provide adequate
liquidity, and over the long term to satisfy loan demand and to provide investment
earnings. The basic concerns of liability management are how a bank can best influence
the volume, cost and stability of the various types of funds it can obtain.
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Asset and Liability Management
Objectives
When a bank needs funds to cover deposit withdrawals or ton expand its loans to acquire
other assets, it can obtain the needed funds in two ways. One way of acquiring funds is to
liquidate some of the short term assets that the bank holds in units liquidity account for
this purpose. A bank can also obtain funds by acquiring additional liabilities i.e. by
buying the funds it needs. Basically, liability management seeks to control the sources of
funds that a bank can obtain quickly and in large amounts, unlike demand and savings
deposits, which cannot be increased to any great degree over a short time period.
Depending on cost and availability, a bank will use a variety of liability management
instruments to obtain the liquidity needed for daily cash management, for loan expansion,
needed funds, and the bank chooses between these alternatives based on the relative costs
and risks involved. For example: depending on a bank’s size and on market conditions, a
bank in need of liquidity may chose to borrow government funds or issue CD’s rather
than sell T bills or other liquid assets. Liability management also provides a bank with an
alternative to asset management in obtaining the greatest value from inflows of funds.
Therefore a bank which follows both assets and liability management strategies has the
option of using cash inflows to obtain more short term liquid assets or to repay
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Asset and Liability Management
adjustments of funds. For example: Assume that the bank experiences a sudden
and unexpected marked decline in the level of its demand deposits. If the bank’s
only source of liquidity is its assets, it must sell some of its securities to obtain the
funds needed to cover the run off of its deposits, whether or not market conditions
are favorable. With liability management, the bank may be able to raise the
needed funds by incurring liabilities, thereby postponing the sale of its assets until
Liability management also provides a bank with the means of funding long term
outstanding at all times so that it can build up on its deposit levels and thereby
expand the level of its loans. This approach of funding is normally followed
within a context of a long term upswing in the economy in which the borrowers
seek more loans for business expansion and depositors place their funds in
management must have a clear idea of the level of outstanding liabilities that it
can count on holding through tight money periods by offering competitive rates.
percentage of its available funds in its securities that provide less liquidity but
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Asset and Liability Management
offer higher earnings, this is possible because the bank’s liquidity account does
not have to bear the full burden of the bank’s liquidity needs. A bank that has the
profitability because it can reduce the amount of short term assets it holds for
liquidity purposes and place those funds into longer term securities that offer less
Although the use of liability management along with asset management allows a
bank the least costly method of obtaining liquidity from a wider range of funding
options, but the added options that liability management provides also require
is so since banks can obtain money market deposits and liabilities only by paying
market rates and the behavior of financial markets cannot be predicted with
complete accuracy.
Another risk involved is that of issuing long term fixed rate CD’s at the peak of
the business cycle. This results in more costly CD’s in the future with a fall in the
interest rates. In fact if short term assets are funded by long term liabilities and
rates subsequently decline, a bank may find that it is paying more for funds than it
Another risks that relates to the changing market conditions is the stability of the
bank’s sources of borrowed or purchased funds. While large money center banks
are usually able to obtain funds under tight money conditions if they are willing to
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Asset and Liability Management
pay market rates, smaller banks may find it impossible to compete for funds when
prices are high. The risk that a funding house may prove unreliable is also a real
problem for smaller banks that move outside their trading areas or that undertake
funding by means of liability instruments with which they are not completely
familiar. Such banks face the very real possibility that their sources of funds may
The basic benefits of liability management lie in the options it provides a bank in
obtaining a least costly method of funding given the bank’s particular needs and the
management basically results from too much reliance on the use of purchased funds
unanticipated changes can have on the bank’s ability to secure funds when the money
is scarce.
The term structure of interest rates, also known as the yield curve, is a very common
bond valuation method. Constructed by graphing the yield to maturities and the
measure of the market's expectations of future interest rates given the current market
conditions. Treasuries, issued by the federal government, are considered risk-free, and as
such, their yields are often used as the benchmarks for fixed-income securities with the
same maturities. The term structure of interest rates is graphed as though each coupon
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Asset and Liability Management
on the coupon payment date. The exact shape of the curve can be different at any point in
time. So if the normal yield curve changes shape, it tells investors that they may need to
There are three main patterns created by the term structure of interest rates:
As its name indicates, this is the yield curve shape that forms during normal market
conditions, wherein investors generally believe that there will be no significant changes
in the economy, such as in inflation rates, and that the economy will continue to grow at a
normal rate. During such conditions, investors expect higher yields for fixed income
instruments with long-term maturities that occur further into the future.
In other words, the market expects long-term fixed income securities to offer higher
yields than short-term fixed income securities. This is a normal expectation of the market
because short-term instruments generally hold less risk than long-term instruments: the
further into the future the bond's maturity, the more time and therefore uncertainty the
bondholder faces before being paid back the principal. To invest in one instrument for a
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Asset and Liability Management
longer period of time, an investor needs to be compensated for undertaking the additional
risk
These curves indicate that the market environment is sending mixed signals to
investors, who are interpreting interest rate movements in various ways. During such
an environment, it is difficult for the market to determine whether interest rates will
A flat yield curve usually occurs when the market is making a transition that emits
different but simultaneous indications of what interest rates will do: there may be some
signals that short-term interest rates will rise and other signals that long-term interest
rates will fall. This condition will create a curve that is flatter than its normal positive
slope. When the yield curve is flat, investors can maximize their risk/return tradeoff by
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Asset and Liability Management
choosing fixed-income securities with the least risk, or highest credit quality. In the rare
instances wherein long-term interest rates decline, a flat curve can sometimes lead to an
inverted curve.
These yield curves are rare, and they form during extraordinary market conditions
wherein the expectations of investors are completely the inverse of those demonstrated by
the normal yield curve. In such abnormal market environments, bonds with maturity
dates further into the future are expected to offer lower yields than bonds with shorter
maturities
The inverted yield curve indicates that the market currently expects interest
rates to decline as time moves further into the future, which in turn means the
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Asset and Liability Management
The Theoretical Spot Rate Curve
Unfortunately, the basic yield curve does not account for securities that have
varying coupon rates. When the yield to maturity was calculated, we assumed that
the coupons were reinvested at an interest rate equal to the coupon rate--therefore,
the bond was priced at par as though prevailing interest rates were equal to the
The spot-rate curve addresses this assumption and accounts for the fact that many
Treasuries offer varying coupons and would therefore not accurately represent similar
paying a 7% coupon with a 10-year Treasury bond that currently has a coupon of 4%,
your comparison wouldn't mean much. Both of the bonds have the same term to
maturity, but the 4% coupon of the Treasury bond would not be an appropriate
benchmark for the bond paying 7%. The spot-rate curve, however, offers a more
accurate measure as it adjusts the yield curve so it reflects any variations in the interest
rate of the plotted benchmark. The interest rate taken from the plot is known as the
spot rate.
The spot-rate curve is created by plotting the yields of zero-coupon Treasury bills and
their corresponding maturities. The spot rate given by each zero-coupon security and
the spot-rate curve are used together for determining the value of each zero-coupon
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Asset and Liability Management
Since T-bills issued by the government do not have maturities greater than
one year, the bootstrapping method is used to fill in interest rates for zero-coupon
process and will not be detailed in this section (to your relief!); however, it is
The credit or quality spread is the additional yield an investor receives for
in the graph below, the spread is demonstrated as the yield curve of the corporate
bond is plotted with the term structure of interest rates. Remember that the term
structure of interest rates is a gauge of the direction of interest rates and the
general state of the economy. Since corporate fixed-income securities have more
risk of default than federal securities, the prices of corporate securities are usually
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Asset and Liability Management
When inflation rates are increasing (or the economy is contracting) the credit spread
between corporate and Treasury securities widens. This is because investors must be
offered additional compensation (in the form of a higher coupon rate) for acquiring the
When interest rates are declining (or the economy is expanding), the credit spread
between Federal and corporate fixed-income securities generally narrows. The lower
interest rates give companies an opportunity to borrow money at lower rates, which
allows them to expand their operations and also their cash flows. When interest rates
are declining, the economy is expanding in the long run, so the risk associated with
Now you have a general understanding of the concepts and uses of the yield curve.
The yield curve is graphed using government securities, which are used as benchmarks
for fixed income investments. The yield curve in conjunction with the credit spread is
used for pricing corporate bonds. Now that you have a better understanding of the
relationship between interest rates, bond prices, and yields, we are ready to examine
the degree to which bond prices change with respect to a change in interest rates.
The general definition of yield is the return an investor will receive by holding a bond
to maturity. So if you want to know what your bond investment will earn, you should
know how to calculate yield. Required yield, on the other hand, is the yield or return a
bond must offer in order for it to be worthwhile for the investor. The required yield of
a bond is usually the yield offered by other plain vanilla bonds that are currently
offered in the market and have similar credit quality and maturity.
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Asset and Liability Management
CALCULATING CURRENT YIELD
A simple yield calculation that is often used to calculate the yield on both bonds
and the dividend yield for stocks is the current yield. The current yield calculates
the percentage return that the annual coupon payment provides the investor. In
other words, this yield calculates what percentage the actual dollar coupon
payment is of the price the investor pays for the bond. (Note that the multiplication
by 100 in the formulas below converts the decimal into a percentage, allowing us
So, if you purchased a bond with a par value of $100 for $95.92 and it paid a coupon
Notice how this calculation does not include any capital gains or losses the investor
would make if the bond were bought at a discount or premium. Because the bond price
compared to its par value is a factor that affects the actual current yield, the above
formula would give a slightly inaccurate answer--unless of course the investor pays
par value for the bond. To correct this, investors can modify the current yield formula
by adding the result of the current yield to the gain or loss the price gives the investor:
[(Par Value – Bond Price)/Years to Maturity]. The modified current yield formula then
takes into account the discount or premium at which the investor paid for the bond.
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Asset and Liability Management
Let's re-calculate the yield of the bond in our first example, which matures in 30
The adjusted current yield of 6.84% is higher than the current yield of 5.21% because
the bond's discounted price ($95.92 instead of $100) gives the investor more of a gain
on the investment.
One thing to note, however, is whether you buy the bond between coupon payments. If
you do, remember to use the dirty price in place of the market price in the above
equation. The dirty price is what you will actually pay for the bond, but usually the
figure quoted in U.S. markets is the clean price. (We explain the difference between
clean and dirty price in the section of this tutorial on bond pricing.)
Now we must also account for other factors such as the coupon payment for a zero-
coupon bond, which has only one coupon payment. For such a bond, the yield
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Asset and Liability Management
If we were considering a zero-coupon bond that has a future value of $1000, that
matures in two years, and can be currently purchased for $925, this is how we would
The current yield calculation we learnt above shows us the return the annual coupon
payment gives the investor, but this percentage does not take into account the time
value of money, or, more specifically, the present value of the coupon payments the
investor will receive in the future. For this reason, when investors and analysts refer to
yield, they are most often referring to the yield to maturity (YTM), which is the interest
rate by which the present values of all the future cash flows are equal to the bond's
price.
An easy way to think of YTM is to consider it the resulting interest rate the investor
receives if he or she invested all of his or her cash flows (coupons payments) at a
constant interest rate until the bond matures. YTM is the return the investor will
receive from his or her entire investment. It is the return you get by receiving the
present values of the coupon payments, the par value, and capital gains in relation to
The yield to maturity, however, is an interest rate that must be calculated through trial
and error. (To find YTM we are essentially solving for “i” in the bond pricing formula
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Asset and Liability Management
we saw in the section on bond pricing.) But such a method of valuation is complicated
typically use a financial calculator or program that is quickly able to run through the
process of trial and error. But, if you don't have such a program, you can use an
To demonstrate this method, we first need to review the relationship between a bond's
price and its yield. In general, as a bond's price increases, yield decreases. This
relationship is measured using the price value of a basis point (PVBP). By taking into
account factors such as the bond's coupon rate and credit rating, the PVBP measures
the degree to which a bond's price will change when there is a 0.01% change in interest
rates
The charted relationship between bond price and required yield appears as a negative
curve:
This is due to the fact that a bond's price will be higher when it pays a coupon that is
higher than prevailing interest rates. As market interest rates increase, bond prices
decrease.
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Asset and Liability Management
The second concept we need to review is the basic price-yield properties of bonds:
reinvested all coupons received at a constant interest rate (which is the interest rate that
we are solving for). If we were to add the present values of all future cash flows, we
would end up with the market value or purchase price of the bond.
OR
You hold a bond whose par value is $100 but has a current yield of 5.21% because the
bond is priced at $95.92. The bond matures in 30 months and pays a semi-annual
coupon of 5%.
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Asset and Liability Management
1. Determine the cash flows: Every six months you would receive a
Remember that we are trying to find the semi-annual interest rate as the
between bond price and yield. When a bond is priced at par, the interest
rate is equal to the coupon rate. If the bond is priced above par (at a
premium), the coupon rate is greater than the interest rate. In our case, the
bond is priced at a discount from par, so the annual interest rate we are
seeking (like the current yield) must be greater than the coupon rate of 5%.
plugging various annual interest rates that are higher than 5% into the
above formula. Here is a table of the bond prices that result from a few
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Asset and Liability Management
Because our bond price is $95.52, our list shows that the interest rate we
are solving for is between 6% (which gives a price of $95) and 7% (which
gives a price of $98). Now that we have found a range between which the
interest rate lies, we can make another table showing the prices that result
1.0%. Below we see the bond prices that result from various interest rates
We see then that the present value of our bond (the price) is equal to
$95.92 when we have an interest rate of 6.8%. If at this point we did not
find that 6.8% gives us the exact price we are paying for the bond, we
would have to make another table that shows the interest rates in 0.01%
increments. (You can see why investors prefer to use special programs to
narrow down the interest rates—the calculations required to find YTM can
be quite numerous!)
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Asset and Liability Management
Calculating Yield for Callable and Puttable Bonds
calculations. A callable bond's valuations must account for the issuer's ability to call
the bond on the call date, and the puttable bond's valuation must include the buyer's
ability to sell the bond at the pre-specified put date. The yield for callable bonds is
referred to as yield-to-call, and the yield for puttable bonds is referred to as yield-to-put.
Yield to call (YTC) is the interest rate that investors would receive if they held the
bond until the call date. The period until the first call is referred to as the call protection
period. Yield to call is the rate that would make the bond's present value equal to the
full price of the bond. Essentially, its calculation requires two simple modifications to
Note that European callable bonds can have multiple call dates, and a yield to call can
Yield to put (YTP) is the interest rate that investors would receive if they
held the bond until its put date. To calculate yield to put, the same
modified equation for yield to call is used except the bond put price
replaces the bond call value, and the time until put date replaces the
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Asset and Liability Management
For both callable and puttable bonds, astute investors will compute both yield and all
yield-to-call/yield-to-put figures for a particular bond, and then use these figures to
estimate the expected yield. The lowest yield calculated is known as yield to worst,
yield. Unfortunately, these yield figures do not account for bonds that are not
Now you know that the yield you receive from holding a bond will differ
from its coupon rate because of fluctuations in bond price and from the
section we will take a closer look at yield to maturity, and how the YTMs
for bonds are graphed to form the term structure of interest rates, or yield
curve.
By convention, the term "money market" refers to the market for short-term
instruments, which have a maturity period of less than one year. The most active part
of the money market is the market for overnight and term money between banks and
institutions (called call money) and the market for repo transactions. The former is in
the form of loans and the latter are sale and buy back agreements – both are obviously
not traded. The main traded instruments are commercial papers (CPs), certificates of
deposit (CDs) and treasury bills (T-Bills). All of these are discounted instruments ie
they are issued at a discount to their maturity value and the difference between the
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Asset and Liability Management
issuing price and the maturity/face value is the implicit interest. These are also
instruments is their high liquidity and tradability. A key reason for this is that these
instruments are transferred by endorsement and delivery and there is no stamp duty or
any other transfer fee levied when the instrument changes hands. Another important
feature is that there is no tax deducted at source from the interest component. A brief
These are issued by corporate entities in denominations of Rs2.5mn and usually have a
maturity of 90 days. CPs can also be issued for maturity periods of 180 and one year
Two key regulations govern the issuance of CPs-firstly, CPs have to be compulsorily
rated by a recognized credit rating agency and only those companies can issue CPs
which have a short term rating of at least P1. Secondly, funds raised through CPs do
not represent fresh borrowings for the corporate issuer but merely substitute a part of
the banking limits available to it. Hence, a company issues CPs almost always to save
on interest costs ie it will issue CPs only when the environment is such that CP
issuance will be at rates lower than the rate at which it borrows money from its
banking consortium.
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Asset and Liability Management
Certificates of deposit (CD):
These are issued by banks in denominations of Rs0.5mn and have maturity ranging
from 30 days to 3 years. Banks are allowed to issue CDs with a maturity of less than
one year while financial institutions are allowed to issue CDs with a maturity of at
least one year. Usually, this means 366 day CDs. The market is most active for the one
year maturity bracket, while longer dated securities are not much in demand. One of
the main reasons for an active market in CDs is that their issuance does not attract
These are issued by the Reserve Bank of India on behalf of the Government of India
and are thus actually a class of Government Securities. At present, T-Bills are issued
in maturity of 14 days, 91 days and 364 days. The RBI has announced its intention to
start issuing 182 day T-Bills shortly. The minimum denomination can be as low as
Rs100, but in practice most of the bids are large bids from institutional investors who
are allotted T-Bills in dematerialized form. RBI holds auctions for 14 and 364 day T-
Bills on a fortnightly basis and for 91 day T-Bills on a weekly basis. There is a
notified value of bills available for the auction of 91 day T-Bills which is announced 2
days prior to the auction. There is no specified amount for the auction of 14 and 364
day T-Bills. The result is that at any given point of time, it is possible to buy T-Bills to
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Asset and Liability Management
Potential investors have to put in competitive bids at the specified times. These bids
are on a price/interest rate basis. The auction is conducted on a French auction basis ie
all bidders above the cut off at the interest rate/price which they bid while the bidders
at the clearing/cut off price/rate get pro rata allotment at the cut off price/rate. The cut
off is determined by the RBI depending on the amount being auctioned, the bidding
pattern etc. By and large, the cut off is market determined although sometimes the RBI
utilizes its discretion and decides on a cut off level which results in a partially
successful auction with the balance amount devolving on it. This is done by the RBI to
Non-competitive bids are also allowed in auctions (only from specified entities like
State Governments and their undertakings and statutory bodies) wherein the bidder is
Apart from the above money market instruments, certain other short-term instruments
are also in vogue with investors. These include short-term corporate debentures, Bills
Like CPs, short-term debentures are issued by corporate entities. However, unlike CPs,
they represent additional funding for the corporate ie the funds borrowed by issuing
short term debentures are over and above the funds available to the corporate from its
consortium bankers. Normally, debenture issuance attracts stamp duty; but issuers get
around this by issuing only a letter of allotment (LOA) with the promise of issuing a
formal debenture later – however the debenture is never issued and the LOA itself is
redeemed on maturity. These LOAs are freely tradable but transfers attract stamp duty.
Bills of exchange
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Asset and Liability Management
These are promissory notes issued for commercial transactions involving exchange of
goods and services. These bills form a part of a company’s banking limits and are
discounted by the banks. Banks in turn rediscount bills with each other.
The primary market also called the new issue market, is that in which newly
issued securities are bought by investors from their issuers. The securities may be
bought with or without the service of the dealers or underwriters. Dealers act as
The secondary market also called as the after market is that in which any later
sales of securities from one owner to another are transacted. while some portion
of the bank’s assets are held to maturity, banks often use the secondary markets to
sell investments before maturity for several reasons which are as follows.
Bank loans and investments move in the opposite directions in a cyclical pattern.
When business activity is slow and loan demand is down, banks invest more
heavily in securities. When business activity picks up and loan demand rises,
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Asset and Liability Management
banks sell their investments to meet their customer needs. Thus one of the major
reasons banks own secondary reserves are to supply the reserves needed to
When yields are expected to rise, banks can sell their longer maturities to avoid
price declines. When yields are expected to fall, banks sell their short term
securities and buy long term investments, whose prices will increase more
rapidly. Sales also may be prompted by the tax advantages of gains or losses.
Banks sell some securities to take more risk and improve average yield. Banks are
loans and investments. A bank adding to the average risk in its loans balance this
added risk by increasing the average credit quality of its credit holdings. In like
manner, if the bank holds loans of above average quality, it can accept greater risk
service to borrowers
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Asset and Liability Management
Underwriters know the current needs of the investors and counsel issuers on those
expected by the investors and the rate of interest required to sell an issue. Bank
loan officers fulfill this function when they evaluate applications for business
loans, mortgage loans, and consumer credit. Loan officers accept or reject
negotiate changes in the terms of the proposals to meet bank standards and to
meet the borrower’s needs and ability to repay the debt when due.
Investment banks and dealers assist the issuer in creating securities that offer
investors an attractive rate of return, liquidity and quality. In shaping the security,
the investment bankers also assist the issuer in registering the security with SEBI.
Purchasing the securities directly from the issuers and adding them to
Underwriters buy the entire issues of securities from the issuer, pay for them in
full and thus provide the issuer with funds for immediate use. Because
preferences, they incur few loses. They fill an important role in the primary
market by channeling new securities from issuers to first owners at current market
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Asset and Liability Management
ASSET MANAGEMENT AND LIQUIDITY ACCOUNT
them by purchasing liabilities or by holding assets that will mature or will be sold
to provide needed liquidity. Here the main concern is asset management for
liquidity i.e drawing liquidity from short term assets that the bank holds in its
Liquid assets are those that can be sold or that which will mature as funds needs
arise. A bank’s liquid assets are expected to return same interest earnings, but
their main purpose is to provide liquidity. The liquidity account and the
Distinction between the two accounts are based on their basic purposes and on the
maturities of the assets held in them. The liquidity account is meant to be used by
reducing and increasing the account holdings as needs arise. Maturities in the
liquidity account are limited to two years although same banks limit maximum
The interest earned on the investment portfolio is often the second-largest revenue
source for banks. In addition to being an important revenue source, the investment
portfolio serves as a secondary reserve to help banks meet liquidity needs. Further, it is
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Asset and Liability Management
The investment portfolio is a key revenue source and liquidity management tool for
banks. When loan demand is low, banks invest excess funds in securities to earn a
return until demand improves. When that occurs, banks sell the securities they
purchased to make loans. Because the investment portfolio plays a critical role in a
bank’s success, its management at most banks is governed by policy. The foundation
for sound management and administration of the investment portfolio is the investment
policy. This policy represents the board of director’s guidance and direction to
Depending upon the bank, the investment policy may be part of the asset and liability
management policy or integrated into other polices the bank feels appropriate. It is
important to note that bank policies are often integrated with one another to ensure
wouldn’t be unusual for the loan policy to do any one of the following (each of these
policy items reflect the terms on which loans are available to the bank’s customers,
• State the type of rate (variable or fixed) that will be offered on credit extended.
LESSON OBJECTIVES
This lesson focuses on basic matters in an investment policy and the risk management
role it plays. After you complete this lesson, you should be able to:
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Asset and Liability Management
• List the purpose of the investment policy.
Like all other policies of the bank, the investment policy is tailored to the special
needs and conditions faced by the bank. Although its primary focus is guiding
investment activities, it takes into account the multiple needs of the bank, providing
requirements)
Maturity and repricing guidelines, setting out the maturity distribution of the
bank’s investments, establishing interest rate terms (fixed or adjustable rate) and
their appropriate use and setting out circumstances for selling specific maturities.
Limitations on quality ratings and the agency issuing the rating. The rating grade
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Asset and Liability Management
Valuation procedure and frequency—the method used to value securities and the
supervisors.
business for the bank and what prior approvals they must have to exercise that
authority.
who approves policy exceptions. Most often it is the board that approves policy
exceptions.
New product review – setting out when a review must be done, of what it must
held, amount of each issue held, purchase price and current market price.
Periodic review—when the board should review the investment policy for its
consistency with the board current tolerance for risk and evolving market
conditions. Also, provides for the periodic independent review of the investment
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Asset and Liability Management
The principal control tools for managing market risk are a bank’s policies.
The investment policy is the primary policy tool for controlling the bank’s market risk
in its securities portfolio. Like other bank policies, it sets out the basic objectives to be
good return, provide ample liquidity and meet pledging requirements. It also covers
What …
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Asset and Liability Management
Are unacceptable investment practices?
Due diligence should be performed before making investments? (That is, what
Reports should be produced on the bank’s securities portfolio and its content?
policies, procedures and control systems that govern the bank’s investment
activities?
When…
Should the board review the investment policy to determine if it reflects the
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Asset and Liability Management
Many banks also have broader interest rate risk policies that address the measurement,
management and control of market risk inherent in the entire balance sheet. In addition
to objectives and authorities, the interest rate risk policy typically addresses:
The type of risk measurement methodology to use (for instance, the Earnings At
Risk (EAR) simulation, the Economic Value of Equity (EVE) simulation, Gap
analysis).
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Asset and Liability Management
Bibliography
http://www.stlouisfed.org/col/director/alco/boardresponse_investmentpoli
cy.htm
www.iimahd.ernet.in\~jrvarma/papers/1jaf3-2.pdf
www.indiainfoline.com
www.investopedia.com
Reference Books
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