Asset Liability Management

INDEX
SR NO. 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. TOPIC EXECUTIVE SUMMARY METHODOLOGY INTRODUCTION TO INDIAN FINANCIAL SYSTEM INTRODUCTION TO FINANCIAL MARKETS INTRODUCTION TO FINANCIAL INSTRUMENTS INTRODUCTION TO FINANCIAL SERVICES INTRODUCTION TO FINANCIAL INSTITUTION BACKGROUND OF CANARA BANK INTRODUCTION TO ASSET LIABILITY MANAGEMENT MEANING OF ASSET LIABILITY MANAGEMENT THEORETICAL DEVELOPMENT ALM PROCESS ADMINISTRATION OF ALM POLICY GUIDELINES 6 7 8 9 10-13 14 15 16-19 20-24 25 26-37 Page No. 3 4 5

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15.

TABULATION AND ANALYSIS OF DATA EMPIRICAL ANALYSIS OF ASSET LIABILITY MANAGEMENT OF MUTUAL TRUST BANK LTD FINDINGS OF ASSET /LIABILITY MANAGEMENT LIABILITY MANAGEMENT AND ITS IMPACT ON PROFITABILITY CONCLUSION RECOMMENDATION BIBLIOGRAPHY

38-39

16.

40-50

17.

51

18. 19. 20. 21.

52-54 55 56 57

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EXECUTIVE SUMMARY

Asset liability management (ALM) is an overall risk management technique for pension funds. ALM requires the board to formulate guidelines for its strategy on contribution and indexing levels, and its attitude to risk. ALM is based on stochastic simulation and is used as a basis for decisions on the distribution of future contributions, funding, and indexing levels. Practicing ALM requires an assets and liabilities committee (ALCO). An ALCO consists of senior pension fund management, with the chief risk officer as chairman. The committee converts the guidelines into formal proposals on the investment strategy and the contributions and indexing policies. ALM does not predict the future, but it gives insight into the possible risks a pension fund is exposed to and how to handle them. An ALM model should be as parsimonious and uncomplicated as possible. The purpose of such models is to act as a tool to help management understand what is really going on, and how to reach responsible and internally consistent decisions.

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METHODOLOGY

PRIMARY DATA I have not collected any primary data for this project.

SECONDARY DATA I have collected secondary data for the project from the books which are provided by the Library and from the websites related to the Mutual Funds and SBI Mutual Funds.

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INTRODUCTION TO INDIAN FINANCIAL SYSTEM

The economic development of a nation is reflected by the progress of the various economic units, broadly classified into corporate sector, government and household sector. While performing their activities these units will be placed in a surplus/deficit/balanced budgetary situations. There are areas or people with surplus funds and there are those with adeficit.A financial system or financial sector functions as an intermediary and facilitates the flow of funds from the areas of surplus to the areas of deficit. A Financial System is a composition of various institutions, markets, regulations and laws, practices, money manager, analysts, transactions and claims and liabilities.

Financial System; The word "system", in the term "financial system", implies a set of complex and closely connected or interlined institutions, agents, practices, markets, transactions, claims, and liabilities in the economy. The financial system is concerned about money, credit and finance-the three terms are intimately related yet are somewhat different from each other. Indian financial system consists of financial market, financial instruments and financial intermediation.

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INTRODUCTION TO FINANCIAL MARKETS

A Financial Market can be defined as the market in which financial assets are created or transferred. As against a real transaction that involves exchange of money for real goods or services, a financial transaction involves creation or transfer of a financial asset. Financial Assets or Financial Instruments represents a claim to the payment of a sum of money sometime in the future and /or periodic payment in the form of interest or dividend. Money Market The money market ifs a wholesale debt market for low-risk, highly-liquid, short-term instrument. Funds are available in this market for periods ranging from a single day up to a year. This market is dominated mostly by government, banks and financial institutions. Capital Market The capital market is designed to finance the long-term investments. The transactions taking place in this market will be for periods over a year. Forex Market The Forex market deals with the multicurrency requirements, which are met by the exchange of currencies. Depending on the exchange rate that is applicable, the transfer of funds takes place in this market. This is one of the most developed and integrated market across the globe.

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INTRODUCTION TO FINANCIAL INSTRUMENTS

A financial instrument is a trad-able asset of any kind, either cash; evidence of an ownership interest in an entity; or a contractual right to receive, or deliver, cash or another financial instrument. According to IAS 32 and 39, it is defined as 'any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity'. Financial instruments can be categorized by form depending on whether they are cash instruments or derivative instruments:

Cash instruments are financial instruments whose value is determined directly by markets. They can be divided into securities, which are readily transferable, and other cash instruments such as loans and deposits, where both borrower and lender have to agree on a transfer.

Derivative instruments are financial instruments which derive their value from the value and characteristics of one or more underlying entities such as an asset, index, or interest rate. They can be divided into exchange-traded derivatives and over-the-counter (OTC) derivatives.

Alternatively, financial instruments can be categorized by "asset class" depending on whether they are equity based (reflecting ownership of the issuing entity) or debt based (reflecting a loan the investor has made to the issuing entity). If it is debt, it can be further categorized into short term (less than one year) or long term. Foreign Exchange instruments and transactions are neither debt nor equity based and belong in their own category.

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INTRODUCTION TO FINANCIAL SERVICES

The financial services sector in India has witnessed a fundamental transformation since the country was liberalized. India, in the last few years, has emerged as the one of the most rapidly growing economies across the globe. The financial services market is growing rapidly, and there is significant potential for further growth. The financial services sector includes broking firms, investment services, national banks, private banks, mutual funds, car and home loans, and equity market Financial Services in India - Key Drivers Indias high savings rate offers significant opportunity to put resources into the financial markets. The country has a favourable demographic profile with a large segment of the population under 30 years. The Census 2011 shows that 56.9 per cent of Indias total population comes in the age group 15 -59 years. The country will witness a sharp decline in the dependency ratio over the next thirty years which will be a great dividend. As the dividend begins to pay off, with the working age-group population rising disproportionately over the next two decades, the savings rate is likely to rise further, according to Mr Pranab Mukherjee, Union Finance Minister

A large, untapped domestic market, with a huge growth potential Presence of financial and capital market mechanisms A large and continuously growing intellectual capital Healthy rate of economic growth

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INTRODUCTION TO FINANCIAL INSTITUTION

The need for setting aside adequate long term funding to finance industrial development was felt when India embarked on its model of planned growth with ambitious growth targets. It was perceived that the banks would not be able to set aside such quantum of long term funding as they were mainly financed by short-term deposits. Moreover, specialized financial institutions would be able to develop expertise in project financing, which was lacking among the banks. The banks were to concentrate on working capital financing. National and state financial institutions were set up to provide such funding to large, medium and small industry. Further a number of specialized institutions were also set up to take care of specific areas or sectors. These institutions were provided access to low cost long-term funds from the banking system for this purpose. The specialized financial institutions mainly act as refinancing institutions in those particular sectors. Banks and financial institutions in case of large loans generally resort to collective lending. Collective funding takes the form of consortium lending or credit syndication. Both types of funding are similar with small differences. One of the main differences being the terms and conditions under which the loan is sanctioned. In consortium lending the terms and conditions are the same for all participating institutions whereas in the case of credit syndication each participating institution can stipulate its own terms and conditions

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BACKGROUND OF CANARA BANK

Canara Bank is a state-owned financial services company in India. It was established in 1906, making it one of the oldest banks in the country. As on 2009 November, the bank had a network of 3057 branches, spread across India. The bank also has offices abroad in London, Hong Kong, Moscow, Shanghai, Doha, and Dubai. Ammembal Subba Rao Pai, a philanthropist, established the Canara Hindu Permanent Fund in Mangalore, India, on 1 July 1906. The bank changed its name to Canara Bank Limited in 1910 when it incorporated. The Government of India nationalized Canara Bank, along with 13 other major commercial banks of India, on 19 July 1969. In 1976, Canara Bank inaugurated its 1000th branch. In 1983, Canara Bank opened its first overseas office, a branch in London. In 1985, Canara Bank acquired Lakshmi Commercial Bank in a rescue. In 1985, Canara Bank established a subsidiary in Hong Kong, Indo Hong Kong International Finance. In 1996 Canara Bank became the first Indian Bank to get ISO certification for Total Branch Banking for its Seshadripuram branch in Bangalore. Canara Bank has now stopped opting for ISO certification of Branches. In 2008-9, Canara Bank opened its third foreign operation, this one a branch in Shanghai.

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INTRODUCTION

Widely known for customer centricity, Canara Bank was founded by Shri Ammembal Subba Rao Pai, a great visionary and philanthropist, in July 1906, at Mangalore, then a small port in Karnataka. The Bank has gone through the various phases of its growth trajectory over hundred years of its existence. Over the years, the Bank has been scaling up its market position to emerge as a major 'Financial Conglomerate' with as many as nine subsidiaries/sponsored institutions/joint ventures in India and abroad. As at March 2011, the Bank has further expanded its domestic presence, with 3253 branches spread across all geographical segments. Keeping customer convenience at the forefront, the Bank provides a wide array of alternative delivery channels that include 2216 ATMs, covering 846 centers. With 100% CBs, the Bank offers technology banking, such as, Internet Banking and Funds Transfer through NEFT and RTGS across all branches The Bank has further enhanced its basket of new tech-products for customer convenience like Canara Gift Cards, Canara Campus Card, Canara Platinum Card, Bills Desk for utility bills payment, Cash withdrawal at Point of Sale (POS) machines at Merchant Establishments, VISA money transfer and the ASBA (Application Supported by Blocked Amount) facility during FY11.

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OBJECTIVES

The main objective of Canara Bank is to serve as the apex institution for term Finance for industry in India. Its objectives include To emerge as a Best Practices Bank by pursuing global benchmarks in profitability, operational efficiency, asset quality, risk management and expanding the global reach. To provide quality banking services with enhanced customer orientation, higher value creation for stakeholders and to continue as a responsive corporate social citizen by effectively blending commercial pursuits with social banking.

FUNCTION

The Canara Bank has been established to perform the following functions- To grant loans and advances to IFCI, SFCs or any other financial institution by

way of refinancing of loans granted by such institutions which are repayable within 25 year? To grant loans and advances to scheduled banks or state cooperative banks by way of refinancing of loans granted by such institutions which are repayable in 15 years? To grant loans and advances to IFCI, SFCs, other institutions, scheduled banks, state co-operative banks by way of refinancing of loans granted by such institution to industrial concerns for exports. To discount or rediscount bills of industrial concerns. To underwrite or to subscribe to shares or debentures of industrial concerns. To subscribe to or purchase stock, shares, bonds and debentures of other financial institutions. To grant line of credit or loans and advances to other financial institutions such as IFCI, SFCs, etc. To grant loans to any industrial concern. To guarantee deferred payment due from any industrial concern. To provide consultancy and merchant banking services in or outside India.

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Subsidiaries The following are the subsidiaries of Canara Bank. Can fin Homes Limited Can bank Factors Limited Can bank Venture Capital Fund Limited Can bank Computer Services Limited Canara Bank Securities Limited Canara Robeco Asset Management Company Limited Can bank Financial Services Limited Canara HSBC Oriental Life Insurance Company Limited

Capital Structure and Operations As on March 31, 2011, the authorized Capital of Canara bank is Rs.3000crores. Issued, subscribed and paid up share capital was Rs.443 crores.Reserves were Rs.17941 crores. Branch Network Canara Bank has a strong pan India presence with 3253 branches and 2216 ATMs,catering to all segments of an ever growing clientele base of about 3.87 crore. Across the borders the Bank has 4 branches, one each at London, Hong Kong, Shanghai and Leicester. Canara Bank is recognized as a leading financial conglomerate in India, with as many as nine subsidiaries/sponsored institutions/joint ventures in India and abroad.

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INTRODUCTION TO ASSET LIABILITY MANAGEMENT

Asset Liability management is very much importance for a bank. Banks are making profit from various services provided to their customers. Banks profit is functions of revenue earned form the assets and the cost incurred for the liability that has occurred for acquiring funds for financing the assets. Proper management of bank assets and liabilities can increase the profitability of the bank. The fuming of these loans and advances and investments comes from liability. So the earnings of a bank ultimately depend on liabilities. Banks have to incur costs for its liability. For example, they have to give interest to the public and also to the lending institutions. So banks liability is not cost free. Efficient use of liabilities depends on effective liability management. Effective liability management indicates that the cost of the liability will be less and also it will less volatile. But less cost and less volatility is inversely related. If we give our concentration only to less cost fund, then the funds will be volatile.

ALM has mainly two components. One is asset management and the other is liability management. Asset management deals with how a manager can appropriately handle the assets of the bank and efficiently use the profitable opportunities. On the other hand, liability management deals with the liability side of the balance sheet. A banks earning or spread is the difference between the revenue generated mainly from the asset side of the business and expense generated mainly from the liability side of the business. The foal of liability management is to gain control over the banks funds sources.

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MEANING OF ASSET LIABILITY MANAGEMENT

Asset-liability management (ALM) is a term whose meaning has evolved. It is used in slightly different ways in different contexts. ALM was pioneered by financial institutions, but corporations now also apply ALM techniques.

Traditionally, banks and insurance companies used accrual accounting for essentially all their assets and liabilities. They would take on liabilities, such as deposits, life insurance policies or annuities. They would invest the proceeds from these liabilities in assets such as loans, bonds or real estate. All assets and liabilities were held at book value. Doing so disguised possible risks arising from how the assets and liabilities were structured.

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THEORETICAL DEVELOPMENT

1. ASSET LIABILITY MANAGEMENT POLICY: Asset Liability Management (ALM) is an integral part of Bank Management; and so, it is essential to have a structured and systematic process for manage the Balance Sheet. Banks must have a committee comprising of the senior management of the bank to make important decisions related to the Balance Sheet of the Bank. The committee, typically called the Asset Liability Committee (ALCO), should meet at least once every month to analysis, review and formulate strategy to manage the balance sheet. In every ALCO meeting, the key points of the discussion should be minted and the action points should be highlighted to better position the banks balance sheet.

Asset Liability management is one of the pillars of banking- in fact the concept of Asset Liability management is at the core of financial business. The

importance of appropriate and effective Asset Liability management has always been outlined by regulators, market operatives and individuals and yet we hear of instances of failures in Asset Liability management mechanism- the most notable amongst them the Barings Bank and Long Term Capital Management.

The Asset Liability Risk Management system essentially focuses on risks that arise out of liquidity and interest rate mismatches and management of Capital Adequacy. This aspect of risk management has become increasingly important due to volatility that arises from a deregulated market- driven environment. Here to the policy guideline, outlines all the areas that are required to be covered through preciously laid down statement on Capital Adequacy,
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borrowing limits commitment limits, loan deposit ratios and medium term funding ratio. The organization structure and job responsibilities are also outlined and the globally accepted ALCO or The Asset Liability Committee process is detailed. The ALCO process ensures that the management is constantly apprised of the risks arising out of liquidity and interest rate mismatch and step can be taken through this continuous monitoring of risk to manage it effectively.

2.

ASSET

LIABILITY

MANAGEMENT

POLICY

EFFICIENT

FRONTIER: The five step ALMEF process: 1. Economic evaluation of the balance sheet which considers the ongoing nature of the business. 2. Evaluation of capital markets employing a stochastic economic simulation model, 3. Surplus optimization utilizing a multi-time period non-linear optimization model which develops efficient frontier portfolios that explicitly consider the liability cash flows and characteristics, as well as being dynamically linked to changing capital market scenarios. 4. Sensitivity testing of key asset, liability and capital market factors. And

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5. A performance measurement system that culminates in a liability benchmark index. The process loops back to step one at various stages and is reevaluated on an ongoing basis. A diagram of the process is provided below. The result is a prospective investment policy and strategy that considers not only the liability profile for the existing balance, but also how the balance sheet will look going forward. Over the last few years the Bangladeshs financial markets have witnessed wide ranging changes at fast pace. Intense competition for business involving both the assets and liabilities, together with increasing volatility in the domestic interest rates as well as foreign exchange rates, has brought pressure on the management of banks to maintain a good balance among spreads, profitability and long-term viability. These pressures call for structured and comprehensive measures and not just ad hoc action. The Management of banks has to base their business decisions on a dynamic and integrated risk management system and
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process, driven by corporate strategy. Banks are exposed to several major risks in the course of their business - credit risk, interest rate risk, foreign exchange risk, equity / commodity price risk, liquidity risk and operational risks.

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ALM PROCESS

The scope of ALM function can be described as follows: Liquidity risk management Management of market risks (Including Interest Rate Risk) Funding and capital planning Profit planning and growth projection Trading risk management The guidelines given in this note mainly address Liquidity and Interest Rate risks. The Asset Liability Committee (ALCO) is responsible for balance sheet (asset liability) risk management. Managing the asset liability is the most important responsibility of a bank as it runs the risks for not only the bank, but also the thousands of depositors who put money into it.

The responsibility of Asset liability Management is on the Treasury Department of the bank. Specifically, the Asset liability Management (ALM) desk of the Treasury Department manages the balance sheet. The results of balance sheet analysis along with recommendation is placed in the ALCO meeting by the Treasurer where important decisions are made to minimize risk and maximize returns. Typically, the organizational structure looks like the following:

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ASSET LIABILITY STRUCTURE OF A BANK:

To understand how a bank operates, first we examine the bank balance sheet, which lists its assets and liabilities. As the name implies, this list balance, that is, it has the characteristics that:Total Assets = Total Liabilities + Capital Furthermore, a banks balance sheet lists sources of banks funds (liabilities) and uses to which they are pit (assets). Banks obtain funds by borrowing and by issuing other liabilities such as deposits. They then use these funds to acquire assets such as securities and loans. The revenue that banks receive from their holdings of securities and loans covers the expenses of issuing liabilities and ideally yields a profit.

Asset Securitization: Against the backing of the secured assets banks issue security paper to raise funds. Securitizing assets requires a bank to set aside a group of income earning assets such as mortgages or consumer loans and to sell securities against those assets in the open market. For example, a bank disbursed loan for two years, so for two years these loans are illiquid. Bank can issue stock for that amount and for two years. The result is that they raise funds. The important issues are that Loans have to be good loans. Not deposit collection is necessary for that purpose. Banks loan and revenues can be increased.

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So, we can say, securitization is the transformation of illiquid assets into security that is tradable and further liquid. The important aspects are Here the institution has to be rated by the credit rating company. Securitization has to be done from similar loans. When banks are offering security, they offer return to investor less than their loan interest but higher than the deposit return.

4.2 Benefits of Securitization: Additional sources of fund: Bank raises funds other than deposit and non-deposit items. Positive effect on balance sheet: Due to of security backed by good loans bank raises funds, part of which is kept as cash balance and most of which is disbursed further as loan for good loan request and for further transformation. So banks risk weighted assets as well as capital adequacy requirements decrease. The result is that banks earning increases. No opportunity cost of fund: Bank does not need to incur anything such as borrowing or deposit collection for raising the funds. So there does not involve any cost. Multiple effects for the development of the economy: By securitization, a bank can raise funds without gong to deposit and non deposit sources. This increases the banks liquidity and profitability. By this process, bank can fund various prospective investment opportunities. It increases more opportunity for the community and helps in increasing the per capita income. Security will not only increase liquidity and reduce pressure on the balance sheet of the bank, but also help to increase the supply of good scripts in the security market. Thus, it ensures the financial development of the country.
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Risk Involved: If backed assets become bad loans then banks will loss those loans as well as has to pay principal and interest tot the investors who bought the security. Any loans pledged behind these securities must be held on the banks balance sheet until the security papers reach maturity, which decreases the overall liquidity of the banks loan portfolio. Moreover, with these loans remaining on its balance sheet the bank must meet the regulatory imposed capital requirements to back the loans.

Loan Selling: It is the selling of some loan to some other intuitions or individuals. It generates cash but it does not require issuing new security paper. Loan selling is both with recourse i.e. if the buyer of the loan become unable to get the money back from the borrower then the seller of the loan will be liable. It may be without recourse i.e. the buyer of the loan will not get protection in case of being unable to collect the loan. The advantages of loan selling are it reduces risk and reduces the pressure on loan. The disadvantage of the loan selling is that due to market pressure; if one sells the good loans, then it will create adverse impact on the financial position of the bank. Loan selling is of following types (a) Loan participation: First the bank is giving loan and then asks some other parties to participate in the process. The participator must the outsider. The participator does not involve in the disbursement of the loan. The buyer of participation will face a substantial loss if the selling institution or the borrower fails.

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(b) Loan striping: A loan strip is short dated pieces of a longer-term loan and often matures quicklya few days or weeks. It is striping some parentage of the loan and sells it to some other institutions. The purchasing institution will be liable for the collection of that portion of the loan. The difference between participation and striping is that in striping a relationship between the buyer of the loan and the borrower creates.

(c) Standby Letter of Credit: It is a financial guarantee in the form of letter of credit. It is mainly practiced in the North American countries. It is made of r two purposes. Performance bond guarantee: in the developed market, nobody will purchase the security paper of any institution without guarantee given by bank.

(d) Default Guarantee: Through it, banks are giving guarantee that if its customer defaults, then the bank will repay the money. This note lays down broad guidelines in respect of interest rate and liquidity risks management systems in banks which form part of the Asset-Liability Management (ALM) function. The initial focus of the ALM function would be to enforce the risk management discipline viz. managing business after assessing the risks involved. The objective of good risk management programmes should be that these programmes will evolve into a strategic tool for bank manageme

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ADMINISTRATION OF ALM
There is a separate department to manage asset and liability. The treasury department maintains asset and liability of a bank. 1 ORGANIZATIONAL STRUCTURE:

CEO / MANAGING DIRECTOR

Head of Consumer Banking

Head of Head of Consumer Banking Treasury

Head of Corporate Banking

Head of Finance

Head of Credit

Head of Operations

Head of Asset Liability Mgt (ALM)

Treasury: Responsible for ALM

Money Market Dealers

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POLICY GUIDELINES:

1 Responsibility of the Board of Directors: The overall responsibility of establishing broad business strategy, significant policies and understanding significant risks of the bank rests with the Board of Directors.

Through the establishment of Audit Committee the Board of Directors can monitor the effectiveness of internal control system. Bangladesh Bank has already instructed the banks to establish Audit Committee.

The internal as well as external audit reports will be sent to the board without any intervention of the bank management and ensure that the management takes timely and necessary actions as per the

recommendations

Have periodic review meetings with the senior management to discuss the effectiveness of the internal control system of the bank and ensure that the management has taken appropriate actions as per the

recommendations of the auditors and internal control.

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2 Responsibility of the Senior Management: In setting out a strong internal control framework within the organization the role of Managing Director is very important. He/she will establish a Management Committee (MANCOM), which will be responsible for the overall management of the Bank

With governance & guidance from the Board of Directors the MANCOM will put in place policies and procedures to identify, measure, monitor and control these risks.

The MANCOM will put in place an internal control structure in the banking organization, which will assign clear responsibility, authority and reporting relationship.

The MANCOM will monitor the adequacy and effectiveness of the internal control system based on the banks established policy & procedure.

The MANCOM will review on a yearly basis the overall effectiveness of the control system of the organization and provide a certification on a yearly basis to the Board of Directors on the effectiveness of Internal Control policy, practice and procedure

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3 ALCO & Asset Liability Management (ALM): The banks asset liability management is monitored through ALCO. The information flow in the ALCO can be diagramed as below:

The Committee: As the Treasury Department is primarily responsible for Asset Liability Management, ideally the Treasurer (or the CEO) is the Chairman of the ALCO committee. The committee consists of the following key personnel of a bank: - Chief Executive Officer / Managing Director - Head of Treasury / Central Accounts Department - Head of Finance
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- Head of Corporate Banking - Head of Consumer Banking - Head of Credit - Chief Operating Officer / Head of Operations The committee calls for a meeting once every month to set and review strategies on ALM.

Key Agendas: ALCO attends the following issues while managing Balance Sheet Risks: i) Review of actions taken in previous ALCO. ii) Economic and Market Status and Outlook. iii) Liquidity Risk related to the Balance Sheet. iv) Review of the price / interest rate structure. v) Actions to be taken.

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4 Policy Recognition and Assessment: An effective internal control system continually recognizes and assesses all of the material risks that could adversely affect the achievement of the banks goals.

Effective risk assessment must identify and consider both internal and external factors. Internal factors include complexity of the organization structure, the nature of the Banks activities, the quality of personnel, organization changes and also employee turnover. External factors include fluctuating economic conditions, changes in the industry, sociopolitical realities and technological advances.

Risk assessment by Internal Control System differs from the business risk management process, which typically focuses more on the review of business strategies developed to maximize the risk/reward trade-off within the different areas of the bank. The risk assessment by Internal Control focuses more on compliance with regulatory requirements, social, ethical and environmental risks those affect the banking industry.

5 ALCO Paper: An ALCO paper is produced every month (usually by the Finance Department) which covers various issues related to Balance Sheet risk management. The ALCO paper is prepared before the ALCO meeting as the committee reviews the ALCO paper to set strategies. An ALCO paper typically covers the following:

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6 The ALCO Process: The ALCO process or the ALCO meeting reviews the ALCO paper along with the prescribed agendas. The Chairman of the committee, that is the Treasurer or the CEO, raises issues related to the balance sheet. Treasurer suggests whether the interest rates need to be reprised, whether the bank needs deposits or advance growth, whether growth of deposits and advances should be on short or longer term, what would be the transfer price of funds among the divisions, what kind of interbank dependency the bank should have etc. In short, all issues related to liquidity and market risk are covered. Based on the analysis and views of the Treasurer, the committee takes decisions to reduce balance sheet risk while maximizing profits.

7 Action Points: The ALCO takes decisions for implementation of any/all of the following issues: Need for appropriate Deposit mobilization or Asset growth in right buckets to optimize asset-liability mismatch. Cash flow (long/short) plan based on market interest rates and liquidity. Need for change in Fund Transfer Pricing (FTP) &/or customer rates in line with strategy adapted. Address to the limits that are in breach (if any) or are in line of breach and provide detailed plan to bring all limits under control. Address to all regulatory issues that are under threat to non-compliance.

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8 Special ALCO Meeting: Apart from the regular monthly meeting, ALCO meeting is also called as and when any contingent situations arise. A very good example may be, during the Eid period. At those times, market liquidity dries out and overnight rates shoot up. Banks who are net borrowers from the market may be exposed to huge interest expense the high rates in the market. This is an ideal time for a special ALCO meeting, where the committee may take critical decisions for deposit mobilization on an urgent basis for reducing dependency from the market.

9 Control Activities and Segregation of Duties:

Effective internal control system requires that an appropriate control structure is set up with control activities defined at every business level, i.e. top level review; appropriate activity controls for different departments or divisions; physical controls; checks for compliance with exposure limits and follow-up on non-compliance; a system for approvals and authorizations and system pf verification and reconciliation.

Control activities involve two steps: (1) the establishment of control policies and procedures and (2) verification that the control policies and procedures are being complied with.

Senior management should ensure that adequate control activities are an integral part of the daily functions of all relevant personnel; this enables quick response to changing conditions and avoids unnecessary costs. Control activities are most effective when they are viewed by
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management and all other personnel as an integral part of daily activities rather than an addition to it.

One of the most important aspects of internal control system requires that there is appropriate segregation of duties and personnel are not assigned conflicting responsibilities.

Furthermore the employees must also be provided with necessary authority, which will enforce segregations of duties. For employees to carry out their responsibilities properly each employee should have appropriate job description

Areas of potential conflicts of interest should be identified, minimized and subject to careful independent monitoring

10 Establishment of a Compliance Culture:

A bank is said to have strong compliance culture when throughout the organization employees are encouraged to comply with policies, procedures and regulation. Even an individual at the lowest echelon should be empowered to speak up without the fear of reprisal if she/he identifies something non-compliant.

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The board of directors and the senior management must establish a compliance culture within the banking organization that emphasizes and demonstrates to all levels of personnel the importance of internal control.

In order to establish a compliance culture the board of directors and senior management must promote a high ethical and integrity standard.

In reinforcing ethical values the banking organization should avoid policies and practices that provide inadvertent incentive for inappropriate activities. Examples of such policies and practices include undue emphasis on performance targets or operational results, particularly short term ones that ignore long term risks and compensation schemes that overly depend on short term performance. The board of directors and the senior management may establish a Code of Ethics that all levels of personnel must sign and adhere to.

The policy statement of Asset Liability Management:

The policy statement of Asset Liability Management is laid out for the followings and annual review would be carried out taking into the conclusion of changes in Balance Sheet and market dynamics.

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a) Advance Deposit Ratio (AD): The bank shall maintain Advance deposit ratio in the following manner: Advance Deposit ratio should be fixed as per guidelines and norms set by the Central Bank of the country. At present the Advance Deposit ratio is 84 %. However, the Loan Deposit ratio of the bank should go up to 110% as per guidelines set in managing core risks in banking, Asset Liability Management. (ALM) To calculate the Advance Deposit ratio, The formula given by the Central Bank to be followed The Loan Deposit ratio = Loan/(Deposit + Capital + Funded Reserve)

b) Wholesale Borrowing Guidelines (WBG): To borrow from wholesale market (or interbank market), the capacity and amount to be determined considering the following factors.

The size and turnover of the local market; our share of that market

The credit limits imposed by our counter parties.

Beside these, the following factors are also to be considered at the time of fixing the amount of borrowing.

Balance sheet size of the bank. Historical trend of market liquidity.

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Credit Rating of the bank (to understand counter party banks limits on the concerned bank). Stability of liquidity and interest rates of the market.

c) Commitments: A register regarding sanction of loans to be introduced. A clause to be inserted in the sanction advice stating the time of taking disbursement. Failing to avail the loan within disbursement time, loan automatically cancelled. During the continuation of time for disbursement, undrawn disbursement amount to be calculated which will be trend as commitment. Commitment amount to be considered for raising funds for the bank along with other factors.

d) Medium Term Funding Ratio (MTF): Central banks guidelines regarding Medium term Funding (MTF) to be followed. Medium term funding ratio to be maintain in conformity with Bangladesh banks directives.

e) Maximum Cumulative Outflow (MCO): Maximum cumulative out flow to be maintained as per Central banks directives and guidelines.

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f) Liquidity Contingency Plan: Liquidity is to be maintained as per Central Banks directives. However, the bank will place the following percentage of its customer deposits with the central bank. CRR 4.5% of average Time and Demand as at two Months prior period (Interest free) SLR 13.5% of average Time and Demand deposits as at two months prior period Foreign currency balance held with central bank will not qualify for CRR.

g) Capital Adequacy Ratio: The bank will maintain a minimum capital on its risk-weighted assets. At present, the minimum capital requirement is at 9 %.

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TABULATION AND ANALYSIS OF DATA:

The collected data have been tabulated after collection. Through tabulation data are condensed into necessary tables. After tabulation data are used for better analysis. Formula Used in Empirical Analysis of Asset Liability Management: Total Assets = Total Liabilities + Capital The Loan Deposit ratio = Loan/(Deposit + Capital + Funded Reserve) Net interest income (NII) = Interest income interest Expense Net interest Margin (NIM) = Net Interest Income Earning Assets

Rate sensitive Assets (RSA) = Rate Sensitive Liabilities (RSL) Interest sensitive gap = interest sensitive assets interest sensitive liabilities GAP=RSA- RSL Gap Relative Gap (RG) = Total Asset NW = A L NW = A L Positive duration gap =Asset duration Liability duration>0 Negative duration gap =Asset duration Liability duration<0 % in market value of security = -(% in interest rate)* duration in year. RSA Interest Sensitivity Ratio = RSL Loan Landing Deposit Ratio = Deposit X 100 Profitability: Return on Assets (ROA) = Net Income / Assets (NI/A)
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Return on Equity (ROE) = Net Income / Equity (NI/E) Return on Earning Assets (ROEA) = Net Income / Earning Assets (NI/EA) Return on Loans (ROL) = Interest Income / Loans (II/L) Interest Income / Earning Assets (II/EA) Net Interest Income / Earning Assets (NII/EA) Interest Margin (IM) = Return on Fund - Cost of Fund (IM)

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EMPIRICAL ANALYSIS OF ASSET LIABILITY MANAGEMENT OF MUTUAL TRUST BANK LTD.

To analyze the asset liability management I have analyzed of a banks

Net

Interest Income, Net Interest Margin (Nim), Gap, Duration, Interest Sensitivity Ratio, Liquidity Ratio. And tried to compare with banks profitability to find that whether there have any relations or not.

Analysis is given below: (a) NET INTEREST INCOME (NII): We know: Net interest income (NII) = Interest income Interest Expense Table I: Net Interest Income Millions) Year 2008 2007 2006 2005 Interest Income 1686.87 1139.96 723.09 457.84 (-) Expense 1258.70 820.68 447.70 330.72 Interest NII 430.17 319.27 245.38 127.12 (Taka in

(Sources: Annual Report of MTBL)

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Here NII is increasing day by day because increase in interest rates earned on asset, otherwise increase in interest paid on funding will decrease NII.

(b) NET INTEREST MARGIN (NIM): We Know: Net interest Margin (NIM) = Net Interest Income Earning Assets

Table 2: Net Interest Margin Millions) Year 2008 2007 2006 2005 Net Interest Income 430.17 319.27 245.38 127.12 Earning Assets 17419.05 14779.16 8300.61 5369.61 NIM 2.46% 2.16% 2.95% 2.36%

(Taka in

(Sources: Annual Report of MTBL)

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Here NIM was highest in 2006, after that gone down in 2007 and again increased in 2008. So we can say that NIMs were on an average sequence and ALM is going on moderate way.

(c) GAP ANALYSIS: Gap management techniques require management to perform an analysis of the maturities and re-pricing opportunities associated with the banks interest sensitive assets, deposits and money market borrowings. A bank can hedge itself by making sure for each time period that Rate Sensitive Assets (RSA) = Rate Sensitive Liabilities (RSL) The most familiar example of re-pricing assets is loans that are about to mature or are coming up for renewal. If interest rate have risen since these loans were first make, the bank will renew them only if it can get an expected yield that approximates the higher yields currently expected on other financial instruments

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of comparable quality. Re-pricing liabilities include CDs about to mature or be renewed, floating rate deposits, and money market borrowings.

Interest Sensitive Gap: A gap exists between these interest sensitive assets and interest sensitive liabilities whenInterest Sensitive Gap = Interest Sensitive Assets Interest Sensitive Liabilities. If interest sensitive assets in each planning period exceed (= >0) the volume of interest sensitive liabilities, the bank is said to have a positive gap and to be asset sensitive. In this situation if interest rate rises, the banks net interest margin will increase because the interest revenues generated by the banks assets will increase more than the cost of borrowed funds and vice-versa. The banks with positive gap will reduce if interest rate falls. In the opposite situation the bank has a negative gap and is said to be liability sensitive. Liability sensitive (negative) gap = interest sensitive assets interest sensitive liabilities < 0. In that case, rising interest rate will lower the banks net interest margin, because the rising cost associate with interest sensitive liabilities will exceed increase in interest revenue from the banks earning assets and vice -versa. Only if interest sensitive assets and liabilities are equal is a bank relatively insulated from interest rate risk. As a practical matter, however, a zero gap does not eliminate all interest rate risk, because the interest rate attached to bank assets and liabilities are not perfectly correlated in the real world. Loan interest rate, for example, tends to lag behind interest rates on money market borrowings. In practical world, zero gaps are also impossible.

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Maturity Gap: The total effect of interest rate change can be summarized by its maturity gap, is the difference between interest Rate Sensitive Assets (RSA) and the interest Rate Sensitive Liabilities (RSL) Rate Sensitive Assets (RSA) of the Bank is Money call at short notice Investment (in shares and securities) Short Term Loan and Advance Non-Banking Asset Rate Sensitive Liabilities (RSL) of the Bank is Borrowing from other banks, financial institutions and agents Deposit and other accounts (except fixed deposits) Total share Holders Equity Relative Gap: Gap Relative Gap (RG) = Total Asset Table 4: Relative Gap Millions) Year 2008 2007 2006 2006 GAP -29776.14 -24713.06 -13587.83 -9903.66 Total Asset 19306.99 15931.03 9037.53 5832.10 Relative Gap Ratio -1.54 -1.55 -1.50 -1.69 (Taka in

(Sources: Annual Report of MTBL)

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Here relative gap is negative but has reduced over the time. It is somehow good sign that they tried to cover-up this Gap.

(d) DURATION ANALYSIS: Duration is a value and time weighted measure of maturity that considers the timing of all cash flows from earning assets and all cash outflows associated with liabilities. In effect, duration measures the average time needed to recover the funds committed to an investment. The net worth (NW) of any bank is equal to the value of its assets (A) less the value of its liability (L): NW = A L As interest rates changes, the value of both a banks assets and liabilities will change, resulting in a change in net worth: NW = A L

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Portfolio Theory of Finance Told That 1. A rise in market rates of interest will cause the market value (price) of both bank fixed-rate assets and liabilities to decline. 2. The longer the maturity of a banks assets and liabilities, the more they in the market value (price) when market interest rates rise.

Duration analysis can be used to stabilize the market value of a banks net worth (NW). It measures the sensitivity of the market value of financial instruments to changes in interest rates. The interest rate risk of financial instruments is directly proportional to their duration. Positive Duration Gap = Asset Duration Liability Duration > 0 Negative Duration Gap = Asset Duration Liability Duration < 0 With liability having a longer duration than the banks assets, a parallel change in all interest rates will generate a larger change in liability values than assets values. If interest rates fall, the banks liabilities will increase more in value than its assets and net worth will decline. If interest rates rise, however, liability values will decrease faster than assets value and banks net worth position will increases in value.

This method of measuring interest rate risk examines the sensitivity of the market value of the banks total assets and liabilities to changes interest rates. Duration is a useful concept because it provides a good approximation of the sensitivity of a securitys market value to a change in its interest rates. % in Market Value of Security = - (% in Interest Rate)* Duration in Year.
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Asset Liability Management

Duration analysis involves comparing the average duration of the banks assets to the average duration of its liabilities. Let us suppose that the average duration of HYPO BANKS assets is 5 years, while the average duration of its liabilities is 3years. With a 5% increase in interest rates, the market v alue of the banks assets fall by 25% = (5%*5 years) and the market value of the liabilities declined by 15%(= - 5%*3 years). The net result is that the net worth has declined by 10% of the total asset value.

The interest sensitive gap is interest sensitive assets minus the interest sensitive liabilities, where interest sensitive assets and liabilities are those items on a banks balance sheet that mature or whose interest rate can be changed during a given interval of time. A bank, which is asset sensitive, will suffer a decline in its net interest margin if market interest rates fall. A bank that is liability sensitive will experience decrease in its met margin if interest rates rise. One of the most popular methods of neutralizing these gap risks is to buy or sell financial futures contracts. A financial futures contract is an agreement between a buyer and a seller reached today that call for the delivery of a particular security in exchange for cash at some future date. The market of futures contract changes daily as the market price of the security to be exchanged moves over time.

The financial futures market are designed to shift the risk of interest rate fluctuations from risk averse investors, such as commercial bank, to speculators willing to accept and possibly profit from such risks. When a bank contracts an exchange broker and offers to sell futures contract, this means it is promising to deliver securities of a certain kind and quality to the buyer of those contracts on a stipulated date at predetermined price. Conversely, a bank may enter the

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future markets as a buyer of futures contracts, agreeing to accept delivery of a particular security named in each contract or to pay cash to the exchangeclearing house the day the contacts mature, based on their price at that time.

A futures hedge against interest rate changes generally requires a bank to take an opposite position in the futures market from its current position in the cash market. Thus, a bank planning to buy bond contracts (go long) in the cash market today may try o to protect the bonds value by selling bond contracts (go short) in the futures market. Then, if bond prices fall in the cash market there will be an offsetting profit in the futures market, minimizing the loss due to changing interest rates

(e) INTEREST SENSITIVITY RATIO: RSA Interest Sensitivity Ratio = RSL

Table 5: Interest Sensitivity Ration in Millions) Year 2008 2007 2006 2005 RSA 2420.93 1585.18 739.51 412.54 RSL 32197.08 26328.25 14327.34 1036.21 ISR 0.075 0.060 0.050 0.039

(Taka

(Source Annual Report of MTBL)

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Here is seen interest sensitivity ratio is always less than 1, A financial institution at a given time asset or liability sensitive, If the financial institution is asset sensitive it will be positive gap, Positive relative gap, Interest sensitivity ratio is greater than 1. If financial institution is liability sensitive it will be negative gap, negative relative gap, and interest sensitivity ratio is less than 1. Here in Mutual Trust Bank Gap is Negative, relative Gap is Negative; Interest Sensitivity Ratio is less than

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LIQUIDITY RATIO: Loan Landing Deposit Ratio = Deposit X 100 Table Six: Liquidity Ratio Millions) Year 2008 2007 2006 2005 Loan 14373.26 11692.97 5904.18 3437.13 Deposit 16098.54 13164.13 7163.67 5158.11 LD Ratio 89.28% 88.82% 82.42% 66.64% (Taka in

(Sources: Annual Report of MTBL)

Liquidity Ratio should be 80% to 85% for a Bank. But here is 64% to 89%. So we can say that they can use their deposits bitterly to earn more profit.

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FINDINGS OF ASSET /LIABILITY MANAGEMENT (ALM):

Here NII is increasing day by day because increase in interest rates earned on asset, otherwise. Increase in interest paid on funding will decrease NII. NIM is here is similar sequence up to 2% that ALM is going on moderately. Here Gap is negative Here Relative Gap is also negative Here is seen Interest sensitivity ratio is always less than 1, Liquidity Ratio should be 80% to 85% for a Bank. But here is 64% to 89%. So we can say that they can use their deposits bitterly to earn more profit. A financial institution at a given time asset or liability sensitive, if the financial institution is asset sensitive it will be positive gap, positive relative gap, interest sensitivity ratio is greater than 1. If financial institution is liability sensitive it will be negative gap, negative relative gap, and interest sensitivity ratio is less than 1 Here in Mutual Trust Bank Gap is Negative, relative Gap is Negative; Interest Sensitivity Ratio is less than 1. So it is a Liability Sensitive Financial Institution.

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LIABILITY MANAGEMENT AND ITS IMPACT ON PROFITABILITY

It is already mentioned that effective liability management depends on less cost and less volatile fund. It also depends on the effective utilization of the collected funds. From the analysis, it is already clear that current deposit is the least costly source of deposited funds whereas fixed deposit is the most costly source of deposited funds. But current deposit is the most volatile sources in nature and fixed deposit is the stable nature. Term deposit is consists of savings and fixed deposit. So, for getting an appropriate liability structure, bank management must make a balance between current and term deposit. It can also use money market borrowing because it is less costly and flexible compared to deposit. A bank can also rely on various off-balance sheet items for funding to its needs. Liability management also depends on the effective use of the collected funds. Improper use makes the collected funds burden for the bank. In this part, various ratios are analyzed both in the context of interest cost of the funds and their effective utilization.

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Profitability Ratios of Mutual Trust Bank Limited: Ratios Return on Assets (ROA) Return on Equity (ROE) Operating Profit Margin Net Interest Margin (NIM) Net Profit (tk in Millions) Earnings per Shares (tk) Price Earnings Ratio (Times) 2008 1.74 21.72 19.90 2.47 336.17 21.07 15.18 2007 1.55 20.30 21.68 2.16 247.19 14.80 40.30 2006 2.106 19.61 26.32 2.95 259.23 16.12 14.32 2005 1.68 30.74 21.51 2.37 187.52 12.38 12.56

The value of ROA and ROE depends on the volume of net income after tax. So, if banks use heavily deposits, especially term deposits as sources of fund then ultimately the interest cost will be increased. As a result values of the mentioned ratios will be decreased. The value of ROA has decreasing trend. The ROA of Mutual Trust Bank Ltd. is growing over the first two years. After 2006 it has increased again. It indicates that the management is somehow able to achieve consistent growth in the banks spread through close control over the banks earning assets and the pursuit of the cheapest sources of funding. If we see only net interest margin (NIM) then the impact of liability management can be realized directly. Because interest expense depends on liability portion but the income portion depends on how one can utilize the funds in an efficient and profitable way. In this case the ratio of net non-interest

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margin and net operating margin can explain the impact of liability on profitability. The vulnerable trend of Earning Spread of Mutual Trust Bank Ltd. reflects the low efficiency of its intermediation functions and its strong position in the competition. A liability structure will be effective only if the bank can earn profit by using it. And the liability will give profit only if it is stable and less costly. In all respect Mutual Trust Bank failed to manage its liability. As Mutual Trust Bank is a service oriented private bank, it cannot say no to the public regarding the acceptance of deposits. The bank has to accept a huge amount of term loan every year. But it does not have the much opportunity to invest those loans. The bank is suffering from bad loans. So, interest revenue from the earning assets is becoming due in every year. It affects the banks net interest margin. In case of investment, Mutual Trust bank invested majority of its funds to advances. It enhances the default risk. The next major portion in the use of fund is money market lending sector. The bank also has to maintain the required provision for classified loans that places an adverse impact on the profit as well as on the capital of the bank.

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CONCLUSION
Mutual Trust bank should have a strong Asset-Liability Management Committee (ALCO) which will develop investment policy guidelines, develop the desired risk-return trade-off, will give decision regarding which types of deposit will be accepted and which type of assets will be financed by which type of liability. Mutual Trust bank should have a clear ALM Policy. In the study it is found that Mutual Trust is utilizing their collected funds properly. Improper use of funds will increase the cost of the liability. Again a bank can make profit even by accepting funds at high cost if it can use the funds properly. The non-interest expense of the bank should be reduced. The bank should accept funds according to the potentiality of investing them. If a bank cannot invest its funds, it will increase the real cost of the fund Strong Money Market should be developed in this country. If strong money market is developed, then a bank can borrow funds from the market as and when required. It will reduce the dependency of the bank on the deposit. As the money market borrowing is less costly compared to deposited funds, it will reduce the banks cost of fund. Mutual Trust Bank should go for new off-balance sheet sources for getting the required funds. It can securitize its assets when it needs funds. Again it can sell the loan to other banks when funds are needed. Other off-balance sheet sources can be used according to their nature.

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RECOMMENDATION
Bank should invest a significant amount in human resources development so that they can form strong human capitals that ultimately contribute to ensure profitability in future. Bank should invest a significant amount in research and developments so that it can identify the appropriate source of funned according to the nature of investment. Bank should have a strong monitoring cell so that the investment cannot be a bad one. In this respect, the cell can give advice to the borrower in technical, financial and other related issues that will ensure the efficient use of funds by the borrower. Mutual Trust Bank should give its customer a greater amount of ancillary service. No funds are involved in providing ancillary services. It will reduce the dependency of the bank on funds, which in turn will increase the fee earnings of the bank. Government must take necessary steps in the development of strong money market in the country.

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BIBLIOGRAPHY

BOOKS: Financial Markets & Services - Gordon - Natarajan

Web Sites: www.wikipedia.com www.canara bank.com www.google.com www.ask.com

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