Grow Through Proactive Risk Management
Background Asset Liability Management Asset Liability management (ALM) can be defined as maximizing the risk-adjusted returns to shareholders over long run. ALM involves techniques to measure the matching of assets […]
Asset Liability management (ALM) can be defined as maximizing the risk-adjusted returns to shareholders over long run. ALM involves techniques to measure the matching of assets and liabilities, thereby assisting in prudent management of the investment portfolio. Thus, the ALM is the management of total balance sheet in terms of size and quality. ALM is aimed for minimizing risks and maximizing returns. The objective of ALM does not necessarily imply achieving a perfect match of assets and liabilities. It is not the exact match that is important but rather the prudent management of mismatch. The focus should be risk control since mismatch will almost always be present. A fully matched position would be one where changes in the present value of assets equal changes in the present value of liabilities.
Risk is the probability of incurring a loss or damage because of actual outcome being different from the expected outcome. This means that, broader the range of possible outcomes, the greater the risk. Risk is the major constraint on investment whilst return on investment is the major opportunity or benefit generated by it.
In early days bankers used to interpret ALM as a system of matching cash inflows and outflows, and thus of liquidity management. They used to think that if a bank meets its cash reserve ratio and statutory liquidity ratio stipulations regularly without undue and frequent resort to purchased funds, they have a satisfactory system of managing liquidity risks, and, hence, of ALM.
However, in these days, managers consider the actual concept of ALM as much wider, and of greater importance to banks’ performance. Historically, ALM has evolved from the early practice of managing liquidity on the bank’s asset side. In a later stage, focus of ALM shifted to the liability side, termed liability management. However, management focus these days both the assets as well as liabilities sides of the balance sheet to achieve optimum resources management. Further, ALM began to extend beyond the bank treasury to cover the loan and deposit functions. The induction of credit risk into the issue of determining adequacy of bank capital further enlarged the scope of ALM.
In the current decade, earning a proper return of bank equity and hence maximization of its market value has meant that ALM covers the management of the entire balance sheet of a bank. This implies that the bank managements are now expected to target required profit levels and ensure minimization of risks to acceptable levels to retain the interest of investors in their banks. This also implies that costing and pricing policies have become of paramount importance in banks.
ALM is one of the tools that is assuming significance as an integral part of Bank Management. Many financial systems in the corporate as well as individual context are underpinned by a cash flow balancing activity. The basic aspect of financial planning encompasses such matching activities of cash flows and is given the generic label: ALM. Fundamentally, when a bank has both assets and liabilities, in the course of business, ultimately the banks have to meet commitment on their liabilities, which are sourcing their assets. Many a time two different situations may arise. Assets with a particular maturity may be greater than the liabilities of the same maturity and vice versa. To avoid this financial quagmire, banks require advanced and meticulous financial planning, and in this context, ALM is invaluable.
The basic objective of ALM is to enforce the risk management discipline viz. managing business after assessing the risks involved. Simply stated, Asset Liability Management is the process of planning, controlling, and monitoring a bank’s (firm’s) assets, liabilities, and capital to achieve financial goals and control financial risk. Today, with an increase in demand for funds, there is a remarkable shift in the features of assets and liabilities of banks. Moreover, intense competition coupled with increasing volatility in the interest rates has prompted the management of banks to strike a balance among spreads, profitability and long-term viability. Therefore, it is imperative for banks to match the maturities of assets and liabilities. Thus, banks in Nepal have started recognizing the importance of Asset Liability Management.
Banks set up ALM Committees (ALCO) consisting of their senior management to manage the bank’s assets and liabilities in order to generate sustained and defined levels of profitability consistent with an acceptable and agreed level of risk. ALCO is responsible for deciding the risk management policy of the bank and set guidelines for liquidity, interest rate, foreign exchange and equity price risks. The management involve ALCO in balance sheet planning from the risk-return perspective. It is also involved in product pricing for both deposits and advances, desired maturity profile of the incremental assets and liabilities, etc.
The ALCO would also articulate the current interest rate view of the bank and base its decisions for future business strategy. For instance, it aids in developing a view on future direction of interest rate movements and decide on a funding mix between fixed vs. floating rate funds, wholesale vs. retail deposits, money market vs. capital market funding, domestic vs. foreign currency funding, etc. Individual banks would decide the frequency for holding their ALCO meetings.
Gap analysis is a technique of asset-liability management used to assess interest rate risk or liquidity risk. This technique is widely adopted by financial institutions these days. When used to manage interest rate risk, it was used in tandem with duration analysis. Both techniques have their own strengths and weaknesses.
Duration is appealing because it summarizes, with a single number, exposure to parallel shifts in the term structure of interest rates. It does not address exposure to other term structure movements, such as tilts or bends. Gap analysis is more cumbersome and less widely applicable, but it assesses exposure to a greater variety of term structure movements.
Liquidity risk refers to the risk of the bank being unable to meet any of its obligations either by being unable to continue to obtain funds to meet any of its commitments or having to pay a substantial premium to do so.
In the commercial environment, retaining the confidence of lenders and depositors will increasingly rely on the maintenance of capital adequacy at or above the prescribed levels, financial ratios that indicate viability and sustainability and generate confidence in the market that the institution is able to manage its exposures and all of the associated risks.
To explain liquidity gap, following example may be considered.
The structure shows that in three months, the Bank will receive cash from maturing assets for NRs 68,677 million. However, in three months, the Bank has maturing liabilities of NRs 45,431 million and needs cash (liquidity) to make the repayment. This results in liquidity surplus of NRs. 23,246 million. However, in next three months, the Bank will have liquidity gap of NRs. 8,333 million. Surplus of earlier period could meet this gap. Earlier surplus could not meet the gap in one year period. The gap could be met by two sources: one is assets maturing in the same period and the other is from an external source.
The 271 – 365 days period maturity shows there will be a liquidity shortfall, a liquidity gap, and the Bank will have to raise funds from an external source before the end of the month. Liquidity gap analysis gives important information on when and how much an institution will need external funds. A resulting fund-raising plan then minimises default probability. However, after one year, the Bank’s negative liquidity gap could be fully squared by surplus resources.
Liquidity gap analysis helps to plan future investment. A negative liquidity gap implies need for future fund raising whereas a positive gap means that future investment is required. The management can forecast costs and returns on the basis of the term structure. So, reallocation of asset and liability can help in managing liquidity gap. Also, the management can lower funding costs and raise investment returns with careful analysis of term structure.
Interest rate risk refers to the potential variability in a bank’s net interest income and market value of equity caused by changes in the level of interest rates. The interest rate risk affects the bank in two ways: by affecting the profits due to changes in interest income and by affecting its balance sheet due to changes in market value of balance sheet items. Thus, one can view interest rate risk as sensitivity of earnings and market value of instruments to changes in interest rates.
There are many constituents of interest rate risk. A change in the interest rate also affects the rate at which the bank reinvests periodic interest payments. Such risk is called the reinvestment risk. A risk caused by the two rates not moving in tandem is called the basis risk. The possibility of getting the market price of the securities decreased due to increase in interest rates is called the price risk. Rate level risk refers to the possibility of a change in the general level of interest rates. Volatility risk is the change in the frequency of interest rate fluctuations, which affects the business volume as well as the pricing of the instruments.
Banks employ various techniques for the management of interest rate risk. Some banks use sensitivity analysis to measure the difference in its rate sensitive assets and rate sensitive liabilities. Splitting of products with uncertain repricing into rate sensitive and rate insensitive balances involves a similar process as their division into core and non-core branches.
A large number of banks use gap analysis to measure the price sensitivity to interest rates. Gap analysis the weighted average maturity with weights expressed in present value terms. Gap analysis helps for managing lending and borrowings. This is because of the notion that the existing balance sheet composition cannot be altered significantly.
One of the ways to eliminate interest rate risk is to have assets and liabilities in such a way that their timings of cash inflows and outflows exactly matches. Banks create dedicated portfolio in such a way. Unfortunately, in is almost impossible to exactly match the cash flows in a portfolio in the real practice. The solution for this problem is to forget the matching the cash flows exactly and concentrate on the value of assets and liabilities and to make the value difference interest rate sensitive.
Banks immunize their portfolio by selecting assets so as to minimize interest rate sensitivity in context of asset-liability management. Since the goal of immunization is to make asset-liability mix insensitive to the interest rate fluctuations, the logical starting point is the measurement of interest rate sensitivity. The most widely used measure for interest rate sensitivity is the duration.
While gap analysis is simple to interpret, it has several limitations. The duration values are reliable over short period of time. As the time passes, the duration of assets and liabilities involves changes and such changes are not equal for all instruments included in a portfolio. As the time passes on, the weighting scheme becomes more unreliable. The duration also changes with yields and these changes are not necessarily the same for all the instruments.
Finding assets and liabilities of similar duration is a difficult task for a banker. It would be much easier if the maturity of a loan or security equaled its duration. However, for financial instruments paying out gradually over time, duration is always less than calendar maturity. The more frequently a financial instrument pays interest or repays the principal, the shorter is its duration. To overcome the limitations stated above, a bank has to compute the duration at frequent intervals and readjust the portfolio accordingly.
Today, banks cannot afford to ignore the importance of Asset Liability Management. Identification of the maturity patterns is gaining importance. For traditional gap analysis to be effective, the presence of an effective management information system is imperative.
Banks should also stress on the setting up of good management information system. A centralized software system facilitates managers to forecast income and portfolio values based on different interest rate assumptions. Such system could use stochastic interest rate models, test alternative hedge strategies in real time, combine forecast assumptions between the risk management and business units using advanced forecasting and planning functionality, simulate prepayments and draw-downs, reduce deployment costs and distribute information easily.
LD Mahat is a Chartered Accountant, Financial Adviser and Risk Management Specialist possessing over 29 years of diverse experience across several sectors covering a wide spectrum of assurance, business advisory and taxation disciplines. LD is a committed, highly motivated and result-oriented professional, consistently developing and nurturing client relationship and building long-lasting relationships with diverse clients. He has the ability to define issues, propose customized solutions that significantly add value and contribute to client’s success.
LD has got master’s in risk management form New York University, Stern Business School. He has undergone executive education at Harvard Business School and Insead Business School. He was risk management specialist in several Asian Development Bank Funded projects. He has provided risk management advisory services in various Nepalese corporate sectors.
LD has worked on large projects jointly with big 4 international accounting firms ~ PwC, Deloittee, Ernst & Young and KPMG in the field of Assurance, Diagnostic Review, Capacity Building, e-Government Procurement, e-Governance, Special Review, Investment Climate, and IFRS Implementation.
Great insights. Thank you for sharing!