in
Commercial Banks
ALM(CB)
asit
ASSET- LIABILITY MANAGEMENT
Asit Mohanty
Outline
• Objectives of ALM
• Scope of ALM
• ALM Products & ALM as Career Option
• ALM Instruments
• Interest Risk Management
• Pricing of Deposits
• Earning at Risk (NII)
• Hedging of Interest Rate Risk
• Loan Pricing ( Base Rate + MCLR)
• Cost of Equity and RAROC
• Modified Duration
• Market Value of Equity
• Approaches to Value at Risk
• Prepayment Model
• Liquidity Risk ( Static and Dynamic)
• Projection of Balance Sheet
• ALM Ratio Analysis
• Asset Backed Securities (ABS) and Mortgage
Backed Securities(MBS)
• Basel III and ALM
• Hands On (Proof of Concept)
• New Generation ALM
• Interest Rate Forecasting Techniques
• ALM & Economics of Securitization of Assets
• Valuation of Banks
• De-monetisation and ALM
• Hands On (Proof of Concept)
OBJECTIVES OF ALM
• TO MANAGE THE LIQUIDITY OF A BANK EFFICIENTLY
– Through the Outflow /Inflow of the existing liability / asset
– Creation of New Business
•Worst Case
& Best Case
ALM Reporting Scenario
ALM Process Flow
Simulations
Periodic
MD ALM MVE
Gap Ratios EaR
Scenario Manager
Projected Balance
Sheet
Scenarios
Projected P&L
• Interest Risk arises from the possibility that profits will change if
rate of interest change.
• The Liquidity Risk arises from the possibility of losses due to bank
having insufficient/surplus cash on hand to pay customers.
• After origination, the assets and liabilities are typically held by the
bank until they mature, although it is becoming increasingly
common to bundle banking products such as loans into
securitization and sell or trade them with other banks.
• http://arcindia.co.in/
Introduction to ALM… ALM Instruments..Contd
U.S Saving & Loan Crises
• The best illustration of ALM Risks is given by U.S (S&L) crisis
(Thrift and Building Society)
• The Commercial Banks in US were mandated by FED… to take
Retail deposits at 4% and can lend to 30 year mortgage loans
at 8%.....the rate are fixed and regulated by the FED. This gives
4% spread.
• In 1980, FED deregulated the rate of interest…as a result the
short term rate rose to 16%....many depositors withdrew their
fund…..re priced at higher rate……however loans were locked
at 8% for 30 years….
• The spread became negative…..most of the Banks went
Bankrupt
• By the end of 1982, massive losses had driven the tangible
capital of the industry down to 0.5% of total assets
• This ALM Risk is combination of Interest Risk
and Liquidity Risk.
• Therefore, the ALM positions makes to measure the risk in the banking
book as well as trading Book.
• For Example, the depositors can any time withdraw their deposits and
borrower can prepay the loans…if the borrower find a cheaper rate else
where.
Introduction to ALM… ALM Instruments..Contd
Global Practice
• Assets
– Retail Personal Loans
– Retail Mortgages
– Credit Card Receivables
– Commercial Loans
– Long Term Investments
– Traded Bonds
– Derivatives…Off Balance Sheet Item
• Liabilities
– Retail Checking accounts
– Retail Saving Accounts
– Retail fixed Deposits accounts
– Deposits from Commercial Customers
– Bonds issued by Bank
Financial Ratio Analysis of Banks
Important Financial Ratios of Banks
(% growth) Business of the Bank
• The higher the ratio, the more the bank is relying on borrowed deposits
rather than own funds
Important Financial Ratios of Banks
1.Growth in Risk Weighted Assets (RWA)
RWAs at the current year end - RWAs at the last year end x100
RWAs at Last Year end
• Any disproportionate increase in RWAs vis-à-vis the growth of total assets
signifies the bank's appetite for assuming more risks for maximizing
returns.
• A critical analysis of the composition of risk-weighted assets is called for.
Important Financial Ratios of Banks
2.Capital to Risk Weighted Asset Ratio (CRAR)….
Risk Weighted Assets ratio
Tier I Capital
Risk Weighted Assets
The ratio should be more than T II Ratio
4.Ratio of debt to Tier I capital
• Expressed in terms of percentage, this ratio shows the ability of a bank to withstand
losses in the value of its assets. The merit of the coverage ratio lies in the fact that it
allows simultaneous monitoring of two important elements, viz., (I) level of non-
performing loans and (ii) equity capital (TI +T2), adverse movements in which have
been found to precede most cases of banking crises.
• As it declines and comes closer to zero, it shows the declining ability of the bank’s
own resources, to cover for non-performing loans.
Important Financial Ratios of Banks
• The ratio reveals the unimpaired capital i.e., Net of Net NPAs available
within the bank to mitigate potential adverse impacts of credit, market
and operational risks. If the ratio is lower than the prudential level of
9%, the cushion available for absorbing future loss is limited.
Important Financial Ratios of Banks
• At present, banks are not permitted to lend more than 15% / 40%(p 165) of their capital
funds to single…SBL and group….GBL (infrastructure projects upto 20/50%) borrowers,
respectively. However, there is no limit on total exposures in excess of a threshold limit,
say 10% of capital funds. The ratio of Large Exposures to capital funds provides a good
measure of concentration risk. The ratio is a better pointer of future asset quality
problems.
• Another way to measure this risk is to calculate the concentration of top 20 accounts in
the overall credit portfolio of the bank. A concentration of over 40% of Total advance is
considered as high-risk portfolio where as concentration lower than 14% is considered
as low risk exposure.
………..30.49%(p165)….
Concentration of NPA
Concentration of Deposits
20 Large depositors(20)
21 Concentration of advances(20)
Important Financial Ratios of Banks
Net Profit…
Total Assets..
– ROA is the financial indicator of the efficiency of banks. A lower ROA signifies poor
return on assets or high operating expenses or losses in loan or investment portfolios.
The analysis of ROA may be extended to Profit Margin (PM) and Asset Utilisation (AU)
Ratios to identify the real reason/s for high/poor ROA. (AU*PM)
– High ROA may be due to excessive risk appetite or trading positions
14. Return on Average Equity
Total Income
Total Assets
• The asset productivity depends on the proportion of earning assets to
total assets of earning base of banks. The earnings could be augmented
through efficient asset allocation. The portfolio changes, i.e. investments
or loans are not only induced by changes in environment but also the yield
differential and changing risk profiles.
Total Income
Total RW Assets
Important Financial Ratios of Banks
15. Return on Risk – Weighted Assets
Net Profit
RW Assets
– The ratio of Return on Assets basically focuses only balance sheet items. Most of the
banks are scouting for off-balance sheet items for fee-based income. This process has
significantly altered the risk profile of banks. Thus, the measure of Return on Risk
Weighted Assets, which captures the off-balance sheet activities of the bank as well
reveal the relationship between the risks and returns. In case the ratio has consistently
been decreasing, it indicates that the bank has not been adequately compensated for
the additional risks assumed. This ratio also recognizes the growing role of fee income
or the differing expense levels in connection with various lines of business.
Important Financial Ratios of Banks
16. Earning Per Share (EPS)…. Net Profit
No. of Equity Shares
17. P/E Ratio
Net interest income or the interest spread, is defined as the difference between
interest income and interest expenses. Interest spread is an important indicator of
efficiency of banking operations. Although higher the spread it is good for the
bank, a higher spread than its peer may not be sustainable in the long run.
The growth of spread in recent years clearly establishes that banks have not fully
passed on the benefit of falling interest rates to their customers.
19. Net Interest Margin (NIM) = Net Interest Income (NII)
Total Earning Assets(RSA)..WF
• Higher the ratios, the Bank is more into other activities other
than lending.
Important Financial Ratios of Banks
• Non-interest expenses ratio (Non-Interest Expenses to Total Income),
The ratios indicate the staff productivity in banks, which is very important in a
competitive environment. A comparison of the ratios among the Peer Group
would reveal efficiency and staff productivity of banks
Profit/Employee …..
Business
Number of employees
Asset Liability Management
Interest Rate Risk (IRR)
Management in Banking Book
Interest Rate Risk (IRR)
Management
Rate Sensitive Assets
• Rate Sensitive Assets: These are those assets that are
sensitive to changes in interest rate movements.
• Non Sensitive Assets
• Cash/ Balances with Central Bank
• Fixed Assets
• Other Assets
• Sensitive Assets:
• Loans
• Investments
• Balances with other banks
• Call Money
Rate sensitivity ….Based upon….. Re
pricing time bucket
• Time Buckets……….8 Time Buckets …based upon Re pricing…Re
pricing Buckets
•
1. 1 to 28 days
2. 29 days and up to 3 months
3. Over 3 months and up to 6 months
4. Over 6 months and up to 1 year
5. Over 1 year and up to 3 years
6. Over 3 years and up to 5 years
7. Over 5 years
8. Non -Sensitive
Current Account…….Non-sensitive.
SB ……RSL
Liability
Rate sensitivity and Re pricing time bucket
• Term Deposits & CD….fixed rate of Interest
• Sensitive….is re priced on maturity. The amounts
should be distributed to different buckets on the basis
of remaining term to maturity.
– Borrowings….Floating Rate
• Sensitive and re prices when interest rate is reset…….. distributed to the appropriate
bucket which refers to the re pricing date.
– Borrowings – Zero Coupon
• Sensitive and re prices on maturity. The amounts should be distributed to the
respective maturity buckets.
• Cash…Non - sensitive.
• Balances with RBI
………….Non - sensitive
• Balances with other Banks
– Current Account………Non - sensitive
– Call Money………….sensitive……. 1-14 days bucket
Asset
Rate sensitivity and Re pricing time bucket
• Investments…… Fixed Rate / Zero Coupon
• Sensitive on maturity
Investments…… Floating Rate
Sensitive at the next re pricing date
• Shares/ Mutual Funds…… Non Sensitive
• Cash Credits / Overdrafts/ Loans repayable on demand and Term Loans
Sensitive only when Base Rate is changed…….Re pricing Date.
If there is anticipation of frequent changes in Base rate, then
time bucket for rate sensitive positions will coincide with
future change in Base Rate/MCLR
For Loan with fixed Rate of Interest…the rate sensitive position
will be reflected at maturity.
Asset
Rate sensitivity and Re pricing time bucket
• Net NPA
Sub-standard Asset(SA)……. Over 3-5 years
bucket…..sensitive during the Recovery period
Doubtful and Loss……… Over 5 years bucket…… sensitive
during Recovery the period
• Fixed Assets…..Non Sensitive
• Reverse Repo……sensitive in 1-14 days bucket
Sample Interest Rate Statement(IRS)
Rs. in Crores
1 – 3 months 3 – 6 months 6 – 12 months
Observations:
•One year cumulative gap is ‘liability sensitive’.
•The increase in interest rate would result in reduction of NII.
•For 1% rise in interest rate, NII will decline by Rs.2 crore.
A TYPICAL INTEREST RATE SENSITIVITY ANALYSIS….interpret
(Rs. in Crores)
RESIDUAL MATURITY TOTAL TOTAL ASSETS GAP
LIABILITIES (B) (C=B-A)
(A)
71
Situation: + ve Gap, Interest View: Decreasing ROI
– Increase RSL or Decrease RSA/both
2003 BPLR - for bringing transparency in lending rates (Banks can not lend
below BPLR)
April,2016 MCLR
Lending Rate
Some Facts
• Sub PLR Lending (PSU) constitutes 67% of Total
Lending as March 2009.
• Sub PLR Lending (Foreign banks) constitutes 81%
of Total Lending as March 2009.
• Sub PLR Lending (Pvt. Sec) constitutes 84% of
Total Lending as March 2009.
PLR…..Extract from Live Mint in 2010
• RBI observed that there is under pricing of credit for corporates, while
there could be overpricing of lending to SMEs
• For the same reason, it was also difficult to assess the transmission of
policy rates of the Reserve Bank to lending rates of banks.
• The Base Rate system will replace the BPLR system with effect from July 1,
2010.
Why Base Rate….
• Issues In Transparency
– No Hidden additional costs
(1) (2)
1 Deposits
a Current Deposits 0.00 7% 0.00
b Savings Deposits 4.00 21% 0.84
c Term deposits *
Upto one month 4.5 2% 0.09
2 Borrowings
RBI 7.25 2% 0.15
• PD*LGD
(VI)Customer Relationship Discount
Interest Rates on Loans
• Using the Capital Asset Pricing Model (CAPM) Approach, the cost of equity
capital (hurdle rate) for any firm is given by the formula:
E(rb) = [rf + β* {E(rm) - rf}]
“Shareholders will require a return from the bank shares in excess of the
risk-free rate to compensate them for undiversifiable risk”
• Relevance of β
• Arises from the regression equation
Signifies the change in the returns for the bank stock for a 1% change in
the market returns
– β >1: bank stock riskier than market; if the market return falls by 1%,
the bank stock is expected to fall by more than 1%
– β <1: bank stock less risky than the market
• Long term investors in the stock of a bank expect to earn a
risk premium in proportion to the β to compensate them for
the higher (or lower) risk of the bank compared to the market
Market Value Approach
DURATION
Discounted 7.34 6.73 6.18 5.67 76.51
value
N
CF t X DFt X t
D t 1
N
CF
t 1
t X DFt
N
wt i i
D i 1
CFt X DFt
wt N
CF
t 1
t X DFt
Modified Duration
• P1 - P0 = - MD* P0 r
• MD = D/ (1+YTM)
• DP =
• P1 - P0 = - MD* P0 r
(P+P) – P > P – (P-P)
P+P”
P
Price
P-P
r-r r r+r
Interest Rate
Total Change
• DP =
1. Calculate the market value of all rate sensitive assets and liabilities by
using appropriate discount.
• If the MDUR Gap of the balance sheet is 1.6 and the MVE is
Rs.500 crores then with a 100 basis points increase in interest
rates, the decline in MVE will be Rs. 8 cr or…..drop by 1.6%.
Modified Duration Gap Analysis
• Compute modified duration of individual items of
assets and liabilities
Interest Rate
Sign MD Gap Movement Change in MVE
- + - +
- + + -
- - - -
- - + +