Asset Liability Management under Risk Framework:

A Critical Study of Indian Banking Industry

- Dr. G.S. Rathore*

Abstract
Today banking is undergoing a rapid transformation in the world in response to the forces of com-
petition, productivity and efficiency of operations, reduced operating margins, better asset / liability
management, risk management, anytime and anywhere banking. The major challenge faced by
banks is to protect the falling margins due to the impact of competition. Falling profit margins call
for increasing volumes so as to result in better operating results for banks. The demand of today’s
marketplace requires a more proactive and integrated view of balance sheet risks and returns. Asset
Liability management (ALM) is a strategic management tool to manage interest rate risk and li-
quidity risk faced by Banks, other financial services companies and corporations. Banks manage
the risks of Asset liability mismatch by matching the assets and liabilities according to the maturity
pattern or the matching the duration, by hedging and by securitization. This paper focuses issues in
asset-liability management and examines strategies for asset-liability management from the asset
side as well as the liability side, particularly in the Indian banking context.

in 2010. In the context of fast moving

Introduction competitive environment, risk management is
Banking sector-a microcosm of the
emerging as an important area which needs a
economy. Changes in the performance of a
great deal of attention. Asset-Liability
bank is reflected in broad indicators such as
Management (ALM) is used as an effective
net worth, Net NPA/Net Advances Ratio,
risk management tools. In India ALM is of
Return on Assets (RoA) and Capital to Risk
very recent origin. RBI had issued guideline
Weighted Asset Ratio (CRAR). As per the
on Feb 10, 1999, for implementation of ALM.
performance Indian banking industry is
It has been implemented wef April 01, 1999.
concerned it shows mixed picture. Between
year 2000 to year 2005, total industry assets Concept
grew from $265 billion to $520 billion, profits Asset-Liability Management (ALM) can be
from $1.7 billion to $5 billion. 2010 termed as a risk management technique
projections- industry assets to exceed $1 designed to earn an adequate return while
trillion, with total profits pegged between $10- maintaining a comfortable surplus of assets
$12 billion. Growth powered by retail assets, beyond liabilities. It takes into consideration
which grew from $9 billion in 2000 to $66 interest rates, earning power, and degree of
billion today- projected to reach $320 billion willingness to take on debt and hence is also
* Reader and Dean, Faculty of Commerce, UP Autonomous College, Varanasi
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known as Surplus Management. Asset-liability bank in line with the banks budget and decided
management basically refers to the process by risk management objectives. ALCO is a
which an institution manages its balance sheet decision-making unit responsible for balance
in order to allow for alternative interest rate sheet planning from a risk return perspective
and liquidity scenarios. Banks and other including strategic management of interest and
financial institutions provide services which liquidity risk. The banks may also authorise
expose them to various kinds of risks like their Asset-Liability Management Committee
credit risk, interest risk, and liquidity risk. (ALCO) to fix interest rates on Deposits and
Asset liability management is an approach that Advances, subject to their reporting to the
provides institutions with protection that Board immediately thereafter. The banks
makes such risk acceptable. Asset-liability should also fix maximum spread over the PLR
management models enable institutions to with the approval of the ALCO/Board for all
measure and monitor risk, and provide suitable advances other than consumer credit.
strategies for their management.
ALM Information System : The ALM
But in the last decade the meaning of Information System is required for the
ALM has evolved. It is now used in many collection of information accurately,
different ways under different contexts. ALM, adequately and expeditiously. Information is
which was actually pioneered by financial the key to the ALM process. A good
institutions and banks, are now widely being information system gives the bank
used in industries too. The Society of Actuaries management a complete picture of the bank’s
Task Force on ALM Principles, Canada, offers balance sheet.
the following definition for ALM: “Asset
Liability Management is the on-going process ALM Process : The basic ALM processes
of formulating, implementing, monitoring, and involving identification, measurement and
revising strategies related to assets and management of risk parameter .The RBI in its
liabilities in an attempt to achieve financial guidelines has asked Indian banks to use
objectives for a given set of risk tolerances traditional techniques like Gap Analysis for
and constraints.” The Indian ALM framework monitoring interest rate and liquidity risk.
rests on three pillars: - However RBI is expecting Indian banks to
move towards sophisticated techniques like
ALM Organisation (ALCO) : The ALCO or Duration, Simulation, VaR in the future. For
the Asset Liability Management Committee the accrued portfolio, most Indian Private
consisting of the banks senior management Sector banks use Gap analysis, but are
including the CEO should be responsible for gradually moving towards duration analysis.
adhering to the limits set by the board as well Most of the foreign banks use duration
as for deciding the business strategy of the analysis and are expected to move towards

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advanced methods like Value at Risk for the The Duration Gap Methodology
entire balance sheet. Some foreign banks are The duration gap methodology should be
already using VaR for the entire balance sheet. implemented by calculating the modified
duration of all assets and liabilities and the
Techniques for assessing Asset-Liability
off-balance sheet items for a bank. Here, the
Risk Techniques for assessing asset-liability
weighted average duration of assets and
risk came to include Gap Analysis, Duration
weighted average duration of liabilities are
Analysis, and Scenario Analysis. These can
used to measure the interest rate risk. Banks
be discussed as follows:
need to compute the duration gap as prescribed
by the RBI.

Calculations for Duration Gap

Duration gap (DGAP) = Weighted average modified duration of assets - Weight *

Weighted average modified duration of liabilities

Where Weight = Risk sensitive liabilities/Risk sensitive assets

Weighted average duration of asset A1 = Weight A1 * Macaulay’s duration of asset A1

Where Weight of an asset = Market value of asset 1/Market value of total assets

Total weighted average duration of assets = Sum of weighted average duration of individual
assets.

Weighted average duration of liability A1 = Weight A1 * Macaulay’s duration of liability A1

Where Weight of liability = Market value of liability 1/Market value of total liabilities

Total weighted average duration of liabilities = Sum of weighted average duration of

individual liabilities

Modified duration of equity = DGAP x Leverage

Leverage = Risk sensitive liabilities/Equity

If the duration of assets is greater than the bank will have to minimize unfavorable
duration of the liabilities, then a rise in the movement in this value due to interest rate
interest rate will cause the market value of fluctuations. The traditional gap method
equity to fall. The market value of equity ignores how changes in interest rates affect
denotes the long-term profits of a bank. The the market value of the bank’s equity.
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Both approaches worked well if assets and be projected under each scenario. If projected
liabilities comprised fixed cash flows. But performance was poor under specific
cases of callable debts, home loans and scenarios, the ALM committee would adjust
mortgages which included options of assets or liabilities to address the indicated
prepayment and floating rates, posed problems exposure. Let us consider the procedure for
that gap analysis could not address. Duration sanctioning a commercial loan. The borrower,
analysis could address these in theory, but who approaches the bank, has to appraise the
implementing sufficiently sophisticated banks credit department on various parameters
duration measures was problematic. like industry prospects, operational efficiency,
Accordingly, banks and insurance companies financial efficiency, management qualities and
started using Scenario Analysis. other things, which would influence the
working of the company. On the basis of this
Under this technique assumptions were
appraisal, the banks would then prepare a
made on various conditions, for example: -
credit-grading sheet after covering all the
• Several interest rate scenarios were aspects of the company and the business in
specified for the next 5 or 10 years. These which the company is in. Then the borrower
specified conditions like declining rates, would then be charged a certain rate of
rising rates, a gradual decrease in rates interest, which would cover the risk of
followed by a sudden rise, etc. Ten or lending.
twenty scenarios could be specified in all.
But the main shortcoming of scenario
• Assumptions were made about the
analysis was that, it was highly dependent on
performance of assets and liabilities
the choice of scenarios. It also required that
under each scenario. They included
many assumptions were to be made about how
prepayment rates on mortgages or
specific assets or liabilities will perform under
surrender rates on insurance products.
specific scenarios. Gradually the firms
• Assumptions were also made about the recognized a potential for different type of
firm’s performance-the rates at which risks, which was overlooked in ALM analyses.
new business would be acquired for Also the deregulation of the interest rates in
various products, demand for the product US in mid 70 s compelled the banks to
etc. undertake active planning for the structure of
• Market conditions and economic factors the balance sheet. The uncertainty of interest
like inflation rates and industrial cycles rate movements gave rise to Interest Rate
were also included. Risk thereby causing banks to look for
processes to manage this risk. In the wake of
Based upon these assumptions, the interest rate risk came Liquidity Risk and
performance of the firm’s balance sheet could Credit Risk, which became inherent
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components of risk for banks. The recognition to fund increases in assets. An
of these risks brought Asset Liability organization has adequate liquidity when
Management to the centre-stage of financial it can obtain sufficient funds, either by
intermediation. Today even Equity Risk, increasing liabilities or by converting
which until a few years ago was given only assets, promptly and at a reasonable cost.
honorary mention in all but a few company Liquidity is essential in all organizations
ALM reports, is now an indispensable part of to compensate for expected and
ALM for most companies. Some companies unexpected balance sheet fluctuations
have gone even further to include and to provide funds for growth. The
Counterparty Credit Risk, Sovereign Risk, price of liquidity is a function of market
as well as Product Design and Pricing Risk conditions and market perception of the
as part of their overall ALM. risks, both interest rate and credit risks,
reflected in the balance sheet and off-
Now a day’s a companies have a different
balance sheet activities in the case of a
reason for doing ALM. While some companies
bank. Liquidity exposure can stem from
view ALM as compliance and risk mitigation
both internally (institution-specific) and
exercise, others have started using ALM as
externally generated factors. Sound
strategic framework to achieve the company’s
liquidity risk management should address
financial objectives. Some of the business
both types of exposure. External liquidity
reasons companies now state for
risks can be geographic, systemic or
implementing an effective ALM framework
instrument-specific. Internal liquidity risk
include gaining competitive advantage and
relates largely to the perception of an
increasing the value of the organization.
institution in its various markets: local,
Asset-Liability Management Approach regional, national or international.

ALM is based on funds management B. Asset Management

which represents the core of sound bank Generally banks tend to have little
planning and financial management. Although influence over the size of their total assets.
funding practices, techniques, and norms have Liquid assets enable a bank to provide funds
been revised substantially in recent years, it is to satisfy increased demand for loans. But
not a new concept. Funds management has banks, which rely solely on asset management,
following three components, which have been concentrate on adjusting the price and
discussed briefly. availability of credit and the level of liquid
A. Liquidity Management assets. However, assets that are often assumed
to be liquid are sometimes difficult to
· Liquidity represents the ability to
liquidate. For example, investment securities
accommodate decreases in liabilities and
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may be pledged against public deposits or comprehensive procedure of reviewing
repurchase agreements, or may be heavily different aspects of internal control, funds
depreciated because of interest rate changes. management and financial ratio analysis.
Furthermore, the holding of liquid assets for Below a step-by-step approach of ALM
liquidity purposes is less attractive because of examination in case of a bank has been
thin profit spreads. outlined.

C. Liability Management First Step

The marginal cost of liquidity and the cost The bank/ financial statements and
of incremental funds acquired are of internal management reports should be
paramount importance in evaluating liability reviewed to assess the asset/liability mix with
sources of liquidity. Consideration must be particular emphasis on: -
given to such factors as the frequency with • Total liquidity position (Ratio of highly
which the banks must regularly refinance liquid assets to total assets).
maturing purchased liabilities, as well as an
• Current liquidity position (Minimum ratio
evaluation of the bank’s ongoing ability to
of highly liquid assets to demand
obtain funds under normal market conditions.
liabilities/deposits).
The obvious difficulty in estimating the latter
is that, until the bank goes to the market to • Ratio of Non Performing Assets to Total
borrow, it cannot determine with complete Assets.
certainty that funds will be available and/or at • Ratio of loans to deposits.
a price, which will maintain a positive yield • Ratio of short-term demand deposits to
spread. Changes in money market conditions total deposits.
may cause a rapid deterioration in a bank’s • Ratio of long-term loans to short term
capacity to borrow at a favorable rate. In this demand deposits.
context, liquidity represents the ability to
• Ratio of contingent liabilities for loans
attract funds in the market when needed, at a
to total loans.
reasonable cost vis-à-vis asset yield. The
access to discretionary funding sources for a • Ratio of pledged securities to total
bank is always a function of its position and securities.
reputation in the money markets. Second Step

Procedure for Examination of Asset Determine that whether bank

Liability Management management adequately assesses and plans its
liquidity needs and whether the bank has short-
In order to determine the efficacy of Asset
term sources of funds. This should include: -
Liability Management one has to follow a

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• Review of internal management reports unanticipated liquidity needs by: -
on liquidity needs and sources of • Determining whether the bank’s
satisfying these needs. management assessed the potential
• Assessing the bank’s ability to meet expenses that the bank will have as a
liquidity needs. result of unanticipated financial or
operational problems.
Third Step
• Determining the alternative sources of
The banks future development and funding liquidity and/or assets subject to
expansion plans, with focus on funding and necessity.
liquidity management aspects have to be
• Determining the impact of the bank’s
looked into. This entails: -
liquidity management on net earnings
• Determining whether bank management position.
has effectively addressed the issue of
need for liquid assets to funding sources Sixth Step
on a long-term basis. Preparing an Asset/Liability Management
• Reviewing the bank’s budget projections Internal Control Questionnaire which should
for a certain period of time in the future. include the following:
• Determining whether the bank really Whether the board of directors has been
needs to expand its activities. What are consistent with its duties and responsibilities
the sources of funding for such expansion and included:
and whether there are projections of
• A line of authority for liquidity
changes in the bank’s asset and liability
management decisions.
structure?
• A mechanism to coordinate asset and
• Determining whether the bank has
liability management decisions.
included sensitivity to interest rate risk
in the development of its long term • A method to identify liquidity needs and
funding strategy. the means to meet those needs.
• Guidelines for the level of liquid assets
Fourth Step
and other sources of funds in relationship
Examining the bank’s internal audit to needs.
report in regards to quality and effectiveness
• Does the planning and budgeting
in terms of liquidity management.
function consider liquidity requirements?
Fifth Step • Are the internal management reports for
Reviewing the bank’s plan of satisfying liquidity management adequate in terms

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 of effective decision making and directly address asset-liability risk by
monitoring of decisions. removing assets or liabilities from their
• Are internal management reports balance sheets. This not only eliminates asset-
concerning liquidity needs prepared liability risk; it also frees up the balance sheet
regularly and reviewed as appropriate by for new business. Today, ALM departments
senior management and the board of are addressing (non-trading) foreign exchange
directors. risks as well as other risks. Also, ALM has
extended to non-financial firms. Corporations
• Whether the bank’s policy of asset and have adopted techniques of ALM to address
liability management prohibits or defines interest-rate exposures, liquidity risk and
certain restrictions for attracting foreign exchange risk. They are using related
borrowed means from bank related techniques to address commodities risks. For
persons (organizations) in order to satisfy example, airlines’ hedging of fuel prices or
liquidity needs. manufacturers’ hedging of steel prices are
• Does the bank’s policy of asset and often presented as ALM. Thus it can be safely
liability management provide for an said that Asset Liability Management will
adequate control over the position of continue to grow in future and an efficient
contingent liabilities of the bank? ALM technique will go a long way in
managing volume, mix, maturity, rate
Conclusion sensitivity, quality and liquidity of the assets
The long-term vision for India’s banking and liabilities so as to earn a sufficient and
system to transform itself from being a acceptable return on the portfolio.
domestic one to the global level may sound
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