ALCO primarily employs these three strategies in order to achieve the objectives referred

above.

Spread Management
Gap Management
Interest rate sensitivity analysis
All the risks that the institution is exposed to, are mainly countered using above mentioned
approaches.

Spread Management
Spread can be defined as the difference between interest earned on deployment of
financial resources and interest earned on required financial resources. Spread is also
known as interest margin.
One of the principle on which bank runs is profitability. To achieve profitability and to
maintain profitability once achieved in the globalised and extremely competitive economic
environment is a big challenge. Targets of profitability directly points towards maximising
spread through various strategies.
Banks are exposed to interest rate risk. Exposure of banks in some asset classes, which
perform cyclically and are not stable income generators, leads banks to have exposure to
cyclical rates. Reducing it helps achieving stabilisation in earnings in long term.
In the era of liberalised economies, banks are exposed to many uncertainties. These
uncertainties might cause unexpected change in rate change which ultimately would affect
the profitability. So, predicting these kinds of rate changes by employing various statistical
tools available would help the bank prepare shield against these risky eventualities.
Banks also need to assess the default risk on deployed financial resources and
accordingly should manage its further investment ensuring good chances of profitability.
This way, probable benefits will balance probable losses and would ensure profitability.

In search of growth, strategies should not aim to achieve extreme targets. Rather, Gradual
improvement in profitability should be targeted to ensured steady and controlled growth.

Gap Management
Gap is essentially the difference between Rate sensitive assets and Rate sensitive
liabilities.
Assets and liabilities which gets impacted by the change in the interest rate are defined as
Rate Sensitive Assets (RSA) & Rate Sensitive Liabilities (RSL) respectively.
Gaps are identified in time buckets which are as under:
1. 1 - 28 days
2. 29 days & upto 3 months
3. Over 3 months & upto 6 months
4. Over 6 months & upto 1 Year
5. Over 1 year & upto 3 years
6. Over 3 years & upto 5 years
7. Over 5 years
8. Non-sensitive
The difference between RSA & RSL is calculated for each time bucket.

Positive Gap: RSA > RSL

Negative Gap: RSL > RSA
As earlier discussed, the aim is to reduce risk and improve profitability. So, reports are
made as to the bank or FI is in a stance to benefit from increasing interest rates by having
Positive Gap (RSA > RSL) or it is in a stance to benefit from decreasing/falling interest
rates by having a Negative Gap (RSL >RSA).
Bases on the view of the potential change in interest rates, banks and financial institutions
aims/sets limits on interest rate gaps in all the time buckets.

Once the benchmark is set, banks which are better equipped to assess rolls-in, rolls-out,
behavioural pattern of various assets and liabilities, classify them in various time buckets
on approval of ALCO
And thus comes the analysis of interest rate sensitivity.

Interest Rate Sensitivity

Interest rate sensitivity may be thought of as an extension to Gap Analysis.
As the name itself suggests, it calculates impact of change in interest rates on the spread
of the bank and ultimately on overall earnings of the bank.
First of all, variable interest rate components of the balance sheet are needed to be
separated from fixed interest rate components. Because, change in interest rates would
affect the variable ones and not the fixed one.
Next step in this is to make assumptions regarding rise and fall in interest rates. These
assumptions need to be realistic based on macroeconomics environment and stance of
the central bank on it.
Moving forward, the next step would be to test impact of assumed changes in the
composition of the portfolio. Change in the size/volume of the portfolio is also needs to be
determined again increase and decrease of interest rates.
To be better able to do the interest rate sensitivity analysis, classification of assets and
liabilities as long term or short term is essential as it provides better view as to more of the
banks assets are interest rate sensitive or not.
The table below summarises, how for a Gap position, change in interest rate s lead to
change in Net Interest Income (NII).
Gap Position

Change in Interest Change in Interest Change in Interest Change in Net

Rate
Income
Expenses
Interest Income

Gap Position

Change in Interest Change in Interest Change in Interest Change in Net

Rate
Income
Expenses
Interest Income