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ASSET LIABILITY MANAGEMENT (ALM)

• Liquidity risk management is a larger part of ALM.
  
• Liquidity risk is the potential inability to meet the bank’s liabilities as they become due. Liquidity risk arises when the banks are unable to generate cash to cope with a decline in deposits or increase in assets. 
• It originates from the mismatches in the maturity pattern of assets and liabilities. 
• The business model of the bank itself is borrowing short and lending long’
• Deposit inflows are for shorter duration and loans are for longer duration. 
• Measuring and managing liquidity needs are vital for effective operation of commercial banks. 

ASSET LIABILITY MANAGEMENT - II 

• By assuring a bank’s ability to meet its liabilities as they become due, liquidity management can reduce the probability of an adverse situation developing.
• Analysis of liquidity risk involves the measurement of not only the liquidity position of the bank on an ongoing basis but also examining how funding requirements are likely to be affected under crisis scenarios – stress testing. 
• Using probability methods to forecast the liquidity gaps forms the crux of liquidity risk management 
• Net funding requirements are determined by analyzing the bank’s future cash flows based on assumptions of the future behavior of assets and liabilities that are classified into specified time buckets and then calculating the cumulative net flows over the time frame for liquidity assessment.

THE LIQUIDITY RISK IN BANKS MANIFEST IN DIFFERENT DIMENSIONS:

i) Funding Risk – need to replace net outflows due to unanticipated withdrawal/non-renewal of deposits (wholesale and retail) 

ii) Time Risk – need to compensate for non-receipt of expected inflows of funds, i.e. performing assets turning into non-performing assets; and 

iii) Call Risk – due to crystallization of contingent liabilities and unable to undertake profitable business opportunities when desirable.

Non fund contractual obligations turning into cash flow commitments leading to higher liquidity gaps. 

STRUCTURAL LIQUIDITY MANAGEMENT 

• In order to enable banks to map the trends of liquidity inflows and outflows, RBI prescribed methodology to capture Maturity Profile  to be used for measuring the future cash flows of banks in different time buckets. 

11 Time buckets for distribution of residual maturity of assets-liabilities 

•  1-28 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 and up to 7 years 8. Non-sensitive Over 7 years and up to 10 years,  9. Over 10 years and up to 15 years10. Over 15 years 11. Non-sensitive 

ALM PROCESS – HOW TO INTEGRATE ITS MANAGEMENT SYSTEM IN THE BANK 

1. ALM Organization 
2. ALM Process
   1. • Risk policies and tolerance limits
      • Risk parameters
      • Risk identification
      • Risk measurement
      • Risk management
3. ALM Information systems

ALM ORGANISATION – I  BOARD OF DIRECTORS 

• The Board of Directors have overall responsibilities for management of integrated risks. Board members must be thoroughly attuned to comprehend balance sheet risk. 
• They should be the main driver of strategy to fix acceptable risk appetite.  
• It should decide risk management policy of the bank and set limits for interest rate, liquidity, foreign exchange and equity price risks and host of interconnected risks

 ASSET LIABILITY COMMITTEE – ALCO TOP LEVEL MONITORING AND POLICY MAKING BODY

• The Asset-Liability Committee consisting of banks senior management including CEO should be responsible for ensuring adherence to the limits set by the Board as well as deciding on the business strategy of the bank (on the assets and liabilities sides) in line with bank’s business plan and decided by risk management objectives.
• ALCO should be apprised about  risks of business and its composition with its implications on the liquidity flows in the bank. 

FUNCTIONS OF ALCO 

1. ALCO is responsible for identifying, managing, and controlling the bank’s balance sheet risks and capital management in executing its chosen business strategy.
2. Balance sheet risks are managed by setting limits, monitoring exposures and implementing controls covering capital funding, liquidity and interest rate risk
3. It is responsible for the implementation of ALCO strategy and policy for the Bank’s balance sheet.

 SCOPE AND RESPONSIBILITIES OF ALCO AMONG MANY, IT SHOULD LOOK AT 

1. Strategic overview
2. Capital
3. Review proposed Foreign Exchange Exposure
4. Liquidity and funding
5. Pricing 
6. Transfer Pricing 
7. Balance sheet Management  - Overall perspectives 
8. Promote and ensure a culture of good corporate governance

 ALM SUPPORT GROUP LINK BETWEEN BOARD, ALCO AND OPERATIONS 

• The ALM support group consisting of operating staff should be responsible for analyzing, monitoring and reporting the risk profile to the ALCO. 
• They also should prepare forecasts (simulations) showing the effects of various possible changes in the market conditions related to the balance sheet and recommend the actions needed to adhere to the bank's internal limits.

 MISMATCH TOLERANCE IN ALM 

• The main focus should be on the short-term mismatches viz., 1-14 days and 15-28 days. Banks, however, are expected to monitor their cumulative mismatches (running total) across all time buckets by establishing internal prudential limits with the approval of the Board / Management Committee. 
• The mismatch during 1-14 days and 15-28 days should not in any case exceed 20% of the cash outflows in each time bucket. 
• If a bank in view of its asset -liability profile needs a higher tolerance level, it could operate with a higher limit sanctioned by its Board / Management Committee giving reasons on the need for such a higher limit. 

GROUPING OF ASSETS AND LIABILITIES IN TIME BUCKETS

• Calculation of the MD of each individual rate sensitive asset, liability and off-balance sheet position and taking their weighted average to derive the MD of RSA and RSL would enhance the accuracy of calculation. However, it may lead to an increase in volume and complexity of calculations. 
• The feasibility of this approach would depend on the bank's information technology infrastructure (availability of core banking solution, MIS capability), staff skills, size of the branch network, etc. 
• Banks have therefore been provided a certain extent of flexibility in applying the proposed framework.

WHAT IS MIDDLE OFFICE IN ALCO REPORTING 

• The Middle Office is responsible for the critical functions of independent market risk monitoring, measurement, analysis, and reporting to ALCO. 
• Middle Office provides the independent risk assessment which is critical to ALCO’s key-function of controlling and managing market risks in accordance with the mandate established by the Board/Risk Management Committee. 
• The Middle Office functions independently of the treasury function. It also independently validates the prices in respect of treasury deals, more particularly in respect of structured products

INTEREST RATE RISK MANAGEMENT – BANKING BOOK (IRRBB)

• Interest rate risk is the risk where changes in market interest rates might adversely affect a bank’s financial condition. 
• The immediate impact of changes in interest rates is on the Net Interest Income (NII). 
• A long term impact of changing interest rates is on the bank’s net worth since the economic value of a bank’s assets, liabilities and off-balance sheet positions get affected due to variation in market interest rates. 
• The interest rate risk when viewed from these two perspectives is known as ‘earnings perspective’ and ‘economic value’ perspective, respectively.

IMPACT OF INTEREST RATE RISK – EARNING PERSPECTIVE 

• Changes in interest rates affect an institution’s earnings by altering interest rate-sensitive income and expenses, affecting its net interest income (NII). 
• In the earnings perspective, the focus of analysis is on the impact of changes in interest rates on accrual or reported earnings. This focus reflects the importance of net interest income (i.e. the difference between total interest income and total interest expense) in banks' overall earnings and its link to changes in interest rates. 
• Unless managed prudently, weakening liquidity, reduced earnings or protracted outright losses, sometimes, can even threaten the solvency of an institution by undermining its capital adequacy that can potentially shake market confidence. 

IMPACT OF INTEREST RATE RISK – ECONOMIC VALUE PERSPECTIVE 

• From an economic value perspective, when interest rates change, the present value and timing of future cash flows change. Such changes will affect the underlying value of an institution’s assets, liabilities and/or off-balance sheet items and, hence, its economic value. 
• The sensitivity of a bank's economic value to fluctuations in interest rates is a particularly important consideration for shareholders, management and supervisors alike. 
• The economic value of an instrument represents an assessment of the present value of its expected net cash flows, discounted by market rates. By extension, the economic value of a bank can be viewed as the present value of bank's expected net cash flows, defined as the present values of expected cash flows on assets minus the present values of expected cash flows on liabilities plus the expected net cash flows on OBS positions.
•  In this sense, the economic value perspective reflects the sensitivity of the net worth of the bank to fluctuations in interest rates. 

 INTEREST RATE RISK MANAGEMENT – ALCO 

• Interest rate risk management is an integral part of the overall risk management framework of a bank. IRR management framework attempts to identify, measure, monitor and control IRR faced by a bank. IRR management in a bank should be appropriate for the level of IRR and the nature, mix, complexity of a bank’s products and activities.
• Typically, ALCO of a bank is responsible for monitoring the balance sheet and interest rate risk in a bank. ALCO is responsible to ensure that bank management receives all relevant information concerning the level and sources of IRR. It confirms that the measurement system adequately captures banks’ interest rate risk exposure. It should establish specific policies and processes including limits for balance sheet management.

IDENTIFICATION OF INTEREST RATE RISK 

• IRRBB arises due to interest rate variability over time, while the business of banking typically involves intermediation activity that produces exposures to both maturity mismatch (e.g., long-maturity assets funded by short-maturity liabilities) and rate mismatch (e.g., fixed rate loans funded by variable rate deposits). 
• In addition, there are options embedded in many of the common banking products (e.g., non-maturity deposits, term deposits, fixed rate loans and mortgage commitments) that may be triggered as a result of changes in interest rates. Interest rate risk can assume many forms.

 IRRBB RISK ARISES DUE TO 1. REPRICING 

• Repricing risk arises when maturity dates or/and repricing dates of interest sensitive assets and interest sensitive liabilities are not matched which has the potential to adversely impact net interest income of a bank. 
• The primary and most often discussed form of interest rate risk arises from timing differences in the maturity (for fixed rate) and repricing (for floating rate) of bank assets, liabilities and off-balance-sheet (OBS) positions. 
• While such repricing mismatches are fundamental to the business of banking, they can expose a bank's income and underlying economic value to unanticipated fluctuations as interest rates vary. 

 IRRBB RISK ARISES DUE TO 2. YIELD CURVE 

• The graphic depiction of the relationship between the yield on bonds of the same credit quality but different maturities is known as the yield curve. 
• Yield-curve risk arises from variations in the movement of interest rates across the maturity spectrum which can have adverse impact on a bank’s income as well as its underlying economic value. This risk involves changes in the relationship among interest rates of different maturities of the same index or market. 
• The relationships change when the slope and shape of the yield curve for a given market flattens, steepens, or becomes negatively sloped (inverted) during an interest rate cycle. Yield-curve variations can impact  the bank’s IRR by amplifying the effect of maturity mismatches.

 IRRBB RISKS ARISES DUE TO – BASIS RISK 

• Another important source of interest rate risk (commonly referred to as basis risk) arises from imperfect correlation in the adjustment of the rates earned and paid on different instruments with otherwise similar repricing characteristics.
•  It arises when market rates for different financial instruments or the indexes used to price assets and liabilities change at different times or by different amounts. 
•  When interest rates change, these differences can give rise to unexpected changes in the cash flows and earnings spread between assets, liabilities and OBS instruments of similar maturities or repricing frequencies. 

MEASURING INTEREST RATE RISK 

• Banks use two basic models to assess interest rate risk. 
• The first, GAP and earnings sensitivity analysis, emphasizes income statement effects by focusing on how changes in interest rates and the bank’s balance sheet affect NII and net income. 
• The second, duration gap and economic value of equity analysis, emphasizes the market value of equity by focusing on how these same types of changes affect the market value of assets versus the market value of liabilities.
• Potentially, three factors can cause variations in the net interest income – 
• Unexpected change in the interest rate
• Change in the mix, composition of assets and liabilities
• Changes in the volume of earnings assets and interest-bearing liabilities.

GAP REPORT 

• One of the key issues in preparing a GAP Report is to identify which assets and liabilities appearing in the balance sheet will be repriced within say 90 days’ time horizon or 1 year time horizon. 
• To repeat the guiding principal assets and liabilities are grouped into different time intervals, or buckets, according to residual maturity or next repricing period whichever is earlier. 
• If any asset or liability matures within a time interval, the principal amount will be repriced whether the interest rates change or not. In case of a 0-90 day time interval, for any investment, loans, deposits or borrowings that matures within 90 days the principal amount is rate sensitive for that time interval.

 TRADITIONAL GAP MODEL – I  

• Traditional GAP model tries to measure the amount of interest rate risk assumed by a bank by comparing the rate sensitive assets with rate sensitive liabilities and by finding out the GAPs over different time intervals based on aggregate balance sheet data at a fixed point in time. 
• Its objectives are to (i) measure expected NII in the short run (usually upto 1 year), (ii) develop strategy to stabilize or improve upon it. 
• The balance sheet is assumed not to change so that GAP reports only rate change effects earnings. The gap report was one of the first models used to measure IRR and remains one of the simplest IRR measurement systems. 
• A gap report can be a useful tool to determine a bank’s asset or liability sensitivity. Gap reports typically include ratios of rate-sensitive assets (RSA) to rate-sensitive liabilities (RSL) in given time periods. Within a given time band, a bank may have a positive, negative, or neutral gap.

 TRADITIONAL GAP MODEL  - WILL ESTABLISH 

• Positive gap: A bank with a positive gap is asset sensitive for the given time band because more assets than liabilities are subject to repricing. An RSA to RSL ratio greater than one suggests that the bank is asset sensitive. 
• Negative gap: A bank with a negative gap is liability sensitive for the given time band because more liabilities than assets are subject to repricing. An RSA to RSL ratio less than one suggests that the bank is liability sensitive.
• Neutral gap: A bank with a neutral gap is neither asset or liability sensitive for the given time band. An RSA to RSL equal to one equates to a neutral gap.

 PERIODIC GAP VS. CUMULATIVE GAP

• Two types of GAP measures find their place in the GAP report. The periodic GAP compares RSAs with RSLs within each of the different time buckets and is a measure of the relative mismatches across time. 
• If RSAs exceed RSLs in each of the following intervals (i) 29 days to 3 months, (ii) more than 3 months to 6 months, (iii) more than 6 months up to 1 year, (iv) more than 3 years up to 5 years and(v) over 5 years. On the other hand, RSLs exceed RSAs in buckets (i)1 to 28 days and (ii) 1 to 3 years.
• Each periodic GAP figure simply indicates whether more assets or liabilities are expected to reprice within a specific time interval. Because it ignores whether assets and liabilities in other periods can be repriced, it is not all that meaningful. 
• Cumulative GAP figures are more important because they directly measure a bank’s net interest sensitivity through the last day of the time bucket by comparing how many assets and liabilities reprice through that last day. 

 GAP RATIO INTERPRETATION TO WORK OUT STRATEGIES TO MANAGE THEM 

• GAP Ratio is GAP divided by Earning Assets or Total Asset as per Banks internal policy. It is a useful tool as a measure of interest rate risk.  The greater this ratio, the greater the interest rate risk. Many banks actually specify a target GAP-to-earning-asset ratio in their ALCO policy statements. 
• Consider a bank with the policy target that the one-year GAP as a fraction of earning assets should be greater than −15 percent and not more than +15 percent. 
• This target allows management to position the bank to be either asset sensitive or liability sensitive, depending on the outlook for interest rates. 

DURATION GAP (DGAP)ANALYSIS FOR 

• Duration gap (DGAP) analysis also known as economic value of equity analysis represents alternative methods of analyzing interest rate risk. 
• In the realm of managing liquidity, interest cost is the most important factor that poses interest rate risk. 
• DGAP analysis captures the sensitivity of the market value or economic value of banks’ equity to changes in interest rate.
•  When interest rates change, the present value and timing of future cash flows change. This in turn changes the underlying values of a bank’s assets, liabilities, and off-balance sheet items and hence their economic value. In other words, the DGAP approach computes the price sensitivity of assets and liabilities to changes in interest rates while traditional GAP analysis emphasizes its earning sensitivity. 

 TRADITIONAL GAP VS DGAP ANALYSIS COMPLEMENTARY TO EACH OTHER 

• On the other hand, the traditional GAP analysis is essentially a going concern analysis trying to capture the effect of change in the interest rate on earnings of a bank as if it continues its operation.
• The economic value measures reflect change in the values of all assets, liabilities, and off-balance sheet items over their remaining life. 
• The traditional GAP approach, on the other hand, covers assets and liabilities repricing or maturing within a short to medium term time horizon usually one to two years. 
• Accordingly, the later approach fails to capture the entire risk which can affect the profit and loss of the bank beyond the period of estimation. 
• Thus they form part of a near term and long term vision of the trends of assets/liabilities that provides a better tool of management.

 MACAULAY DURATION MODEL 

• Frederick Macaulay, a Canadian economist, introduced the concept of ‘duration’ in 1938 to measure the effective maturity of any fixed income instruments.
•  Macaulay’s duration equals the weighted average of the times to each future cash flows received from the instrument (interest or principal payment). 
• The weight associated with each cash flow clearly reflects its relative “importance” to the value of the bond. In fact, the weight applied to each payment time is the present value of the payment divided by the bond price.

WHAT IS MODIFIED DURATION 

• The modified duration is a yield duration statistic that measures interest rate risk with reference to a change in the yield-to-maturity (ΔYield) of a bond. 
• On the other hand, effective duration is a curve duration statistic that measures interest rate risk in terms of a parallel shift in the benchmark yield curve (ΔCurve).

INTERPRETATION OF MODIFIED DURATION 

• The greater the duration of a security, the greater the percentage change in the market value of the security for a given change in interest rates, therefore, greater is the interest-rate risk.
• Further, we can also conclude that bonds with equal duration would have equal interest rate sensitivity and the percentage price change. This, in fact, is the principle behind the immunization strategy applied to bond portfolios. 

 MODIFIED DURATION GAP 

• The MDG as defined above reflects the degree of duration mismatch in the RSA and RSL in a bank’s balance sheet. 
• Specifically, the larger this gap in absolute terms, the more exposed the bank is to interest rate shocks. 

IMPACT OF INTEREST RATE RISK ON BANKING BOOK (IRRBB)

• Interest rate risk could possibly adversely impact banks’ capital and earnings arising from adverse movements in interest rates that affect its banking book positions.
• Banks should be able to identify, measure, monitor and control IRRBB, consistent with the approved strategies and policies.

Interest rate Risk Management Strategy –I  (Based on new RBI guidance issued on 17th February 2023) 

• Banks should incorporate Board-approved risk appetite statements taking into account the bank’s business strategies prescribing policies and procedures for limiting and controlling IRRBB.
• Board will be responsible for ensuring that steps are taken by the bank to identify, measure, monitor and control IRRBB, consistent with the approved strategies and policies.
• Banks disclose their exposure to IRRBB in terms of potential change in the economic value of equity and net interest income, computed based on a set of prescribed interest rate shock scenarios.
• ALCO (asset-liability committee), which should regularly monitor the nature and the level of the bank’s IRRBB exposure.

INTEREST RATE RISK MANAGEMENT STRATEGY – II 

• The Board/ALCO (Asset-Liability Co) to set appropriate limits on IRRBB; valuing positions and assessing performance, including procedures for updating interest rate shock and stress scenarios
• It should document key underlying assumptions driving the institution’s IRRBB analysis; and a comprehensive IRRBB reporting and review process to be institutionalized. 
• Clearly specified sub-limits may also be identified for individual business units, portfolios, instrument types or specific instruments, depending on the nature of a bank’s activities and business model.
• The risk appetite framework should delineate delegated powers, lines of responsibility and accountability over IRRBB management decisions and should clearly define authorized instruments, hedging strategies and risk-taking opportunities.

IDENTIFY IRRBB IN PRODUCTS

• Banks have been asked to identify the IRRBB inherent in products and activities and ensure that these are subject to adequate procedures and controls.
• Significant hedging or risk management initiatives must be approved before being implemented.
• “Products and activities that are new to a bank must undergo a careful pre-acquisition review to ensure that the IRRBB characteristics are well understood and subject to a predetermined test phase before being fully rolled out.
• “Prior to introducing a new product, hedging or risk-taking strategy, adequate operational procedures and risk control systems must be in place,” it said.
• Banks are required to have systems in place to ensure that positions which exceed or are likely to exceed limits defined by the Board should receive prompt management attention and be escalated without delay.
• The RBI said banks should have their IRRBB identification, measurement, monitoring and control processes reviewed by an independent auditing function (such as an internal or external auditor) on a regular basis. All IRRBB policies should be reviewed periodically (at least annually) and revised as needed.

 STRESS TESTING FRAMEWORK

• The central bank asked banks to develop and implement an effective stress testing framework for IRRBB as part of their broader risk management and governance processes, which should be commensurate with their nature, size and complexity as well as business activities and overall risk profile.
• This framework should feed into the decision-making process at the appropriate management level, including strategic decisions (e.g. business and capital planning decisions) of the Board or its Committee.
• In particular, IRRBB stress testing should be considered in the Internal Capital Adequacy Assessment Process (ICAAP), requiring banks to undertake rigorous, forward looking stress testing that identifies events of severe changes in market conditions which could adversely impact the bank’s capital or earnings, possibly also through changes in the behavior of its customer base.

 CAPITAL ADEQUACY FOR IRRBB

• The capital adequacy for IRRBB should be considered in relation to the risks to economic value, given that such risks are embedded in banks’ assets, liabilities and off-balance sheet items, per the guidelines
• For risks to future earnings, given the possibility that future earnings shall be lower than expected, banks should consider capital buffers.
• The RBI said the date for implementation of the guidelines on IRRBB will be communicated in due course. Banks have been advised to be in preparedness for measuring, monitoring, and disclosing their exposure to interest rate risk in the banking book in terms of this circular.