Understanding “Asset Liablity Management” in detailed simple terms.

Understanding “Asset Liablity Management” in detailed simple terms.

Background First:

India has history of deregulating interest rates and amongst others one such instance was on 25th October, 2011. It was 2nd Quarter Monetary Policy Review by RBI, 2011-12. Deregulating interest rates means now RBI will not interfere on what interest rates the bank will charge and banks are free to determine their own interest rates. In this quarterly review banks were allowed to set savings a/c interest rate as per certain conditions (which are not important here).            

When RBI brings any such de-regularization policy which allows bank to set their own parameters, then there is risk that the money managed by bank might get defaulted, risk of bank’s bankruptcy and so on. Hence, a concept was coined for managing the Asset and Liabilities of Banks which we call ALM. RBI, therefore issued ALM Guidelines which banks has to follow so as to reduce the risk the banking system as a whole carries.

You can get all those policy guidelines at RBI’s official website. But here our focus is on ALM.

Asset – Liability Management (ALM):

ALM in simple terms mean managing Assets and Liabilities. Assets for the banks are loans given by bank to others, Investment done by bank, Deposit with RBI, etc. Liabilities are the money received in bank in form of FD, Deposits, Debentures and Bills issued. Etc.

            Now, it becomes important for banks to manage these assets and liabilities on regular basis. This is done to mitigate the risk of any mismatches between asset and liability which may, in future lead to crises. But, how to manage these Assets and Liabilities?

Taking simply with an example, consider a bank has received deposits from its customers to tune of Rs 2,50,00,000/- for which they have to pay them 5% interest on an average. Now we know that banks will have to repay this principle amount back and along with interest of 5% which makes an annual interest payment of Rs. 12,50,000/-. So, to manage this liability banks will have to invest in Assets whose inflow will exactly match the liability payments they have to make. In other words, the Cash Outflow of Liabilities should match the Cash Inflow of Assets. For this, Bank will make an investment of Rs. 1,00,00,000/- earning them rate of 12.5%. Hence interest on liability of Rs. 12,50,000/- will exactly offset the interest income from the asset. Apart from these, banks will have to keep and additional of Rs. 1,50,00,000/- as free idle cash to repay the liability principle amount.

Hence, by the above example. ALM manages the Cash Inflow and Outflow of the Banks Assets and Liabilities. Matching the Inflow and Outflow is very challenging task and it is not easy as it sounded in the above example for obvious reasons that there might be uncertain interest rates, different maturities of liabilities and assets, risk of individual asset classes and liabilities to be considered and so on.

In the ALM mechanism, the banks have to group these assets and liabilities in the time slots of the duration (maturity). Assets in these time slots are to be matched with liabilities in the corresponding time slot. Any differences, whether positive or negative are called Mismatches. Hence, banks uses various techniques to manage these Mismatches and their Liabilities as a whole.

One such techniques is called GAP Analysis. GAP Analysis is used to assess the Interest rate risk or liquidity risk on the Rate sensitive assets (RSA) and Rate sensitive liabilities (RSL). GAP = RSA – RSL. These RSA and RSL are basically floating rate (interest is not fixed but variable) interest loans and deposits and also these have premature (before maturity) withdrawal and repayment option. When GAP is positive, it means Assets > Liabilities and therefore banks can deploy excess cash in money markets or create new assets. Opposite to it, when GAP is negative, Liabilities > Assets, banks have to finance this liabilities by borrowings from various other sources.

Other techniques include Duration Analysis, Scenario Analysis, etc. In duration analysis, banks will first understand the average maturity of its liabilities and assets and will conduct an analysis of impact of liabilities and assets of different maturities with change in interest rates, credit ratings, etc. In Scenario Analysis, trial and error tests are run for different weird scenarios and how will these situations impact Assets and Liabilities value. These scenarios includes declining interest rates, rising interest rates, a gradual decrease in rates followed by sudden rise, assumptions relating to factors like prepayment rates on mortgages etc.

These techniques are employed so that banks can well be prepared to react to mismatches between Assets and Liabilities. To ensure that banks follow the ALM techniques properly, RBI has made it compulsory to set up ALCO (Asset-Liability Committee) based on certain conditions, if fulfilled. This committee will decide on the desired maturity profile of the incremental assets and liabilities, monitoring the risk levels of the banks, also to articulate current interest rates view of the bank and base its decisions for future business strategy. There are many of these duties and responsibilities on ALCO.

Conclusion:

Hence, ALM is important tool to manage risk, monitor risk, work efficiently and avert any possible future defaults and bankruptcy. To give you glimpse of how actual ALM calculation looks like, here is a snapshot of Bajaj Finserv’s December, 2019 record:

You must see how excess liablity are to be adjusted in ALM.
Bajaj Finserve’s snapshop as on December, 2019

Source of Article:

Thank you folks for patiently reading the article. I have used many sources so that I can bring this kind of explanation to you regarding ALM. Few sources are listed below: