ALM & Risk Management
The ALM function of a financial organization focuses on interest rate risk and liquidity risk. Many large banks have operations referencing different currencies, and therefore encounter multiple liquidity and interest rate risks. The institution may choose to operate numerous individual treasuries, each of which manage different currencies, or alternatively may centralize the ALM function in the home currency. Expected future cash flows in foreign currencies are translated into domestic equivalents using the spot/forward foreign exchange market. Local treasuries can borrow from/lend to the central treasury using foreign exchange instruments.
Asset and Liability bank management is an integral part of the financial management process of any bank. Asset and Liability bank management is concerned with strategic balance sheet management involving risks caused by changes in the interest rates, exchange rates and the liquidity position of the bank. While managing these three risks forms the crux of ALM, credit risk and contingency risk also form a part of the ALM.
ALM can be termed as a risk management technique designed to earn an adequate return while maintaining a comfortable surplus of assets beyond liabilities. It takes into consideration interest rates, earning power, and degree of willingness to take on debt and hence is also known as Surplus Management.
ALM is defined as, the process of decision – making to control risks of existence, stability and growth of a system through the dynamic balances of its assets and liabilities. The text book definition of ALM is a risk management technique designed to earn an adequate return while maintaining a comfortable surplus of assets beyond liabilities. It takes into consideration interest rates, earning power and degree of willingness to take on debt. It is also called surplus- management.
The purpose of asset and liability management is to formulate and undertake activities that shape the balance of the bank as a whole. The main objectives of asset and liability management are:
• maximize, or at least stabilize the bank margin (the difference between interest income and expense)
• maximize, or at least to protect the value (stock price) of a bank with an acceptable level of risk.
RISK Management by ALM desk
When the interest rates on financial market changes, changes affecting the most important source of income for banks – interest income on loans and securities – and the most important source of cost – the cost of interest on deposits and other assets that the bank has lent. Changing interest rates also change the market value of assets and liabilities of banks changing the bank’s net worth, i.e. value of equity role in bank. Risk management is the process by which managers satisfy these needs by identifying key risks, obtaining consistent, understandable, operational risk measures, choosing which risks to reduce and which to increase and by what means, and establishing procedures to monitor the resulting risk position. The ALM or balance sheet can often be managed aggressively through the use of derivative contracts. Funds transfer pricing mechanisms are used extensively to create economic transparency and to immunize business units to risk.
Interest Rate Risk
Risks of having a negative impact on banks future earnings and on the market value of its equity due to changes in interest rates.
The phased deregulation of interest rates and the operational flexibility given to banks in pricing most of the assets and liabilities have exposed the banking system to Interest Rate Risk. Interest rate risk is the risk where changes in market interest rates might adversely affect a bank’s financial condition. Changes in interest rates affect both the current earnings (earnings perspective) as also the net worth of the bank (economic value perspective). The risk from the earnings’ perspective can be measured as changes in the Net Interest Income (Nil) or Net Interest Margin (NIM). In the context of poor MIS, slow pace of computerization in banks and the absence of total deregulation, the traditional Gap analysis is considered as a suitable method to measure the Interest Rate Risk.
Techniques of Interest Rate Risk measurement like Duration Gap Analysis, Simulation and Value at Risk are used.
The Gap or Mismatch risk can be measured by calculating Gaps over different time intervals as at a given date. Gap analysis measures mismatches between rate sensitive liabilities and rate sensitive assets (including off-balance sheet positions).
An asset or liability is normally classified as rate sensitive if:
i) Within the time interval under consideration, there is a cash flow;
ii) The interest rate resets/reprises contractually during the interval;
iii) Central bank changes the interest rates (i.e. interest rates on Savings Bank Deposits, , DRI advances, Export credit, Refinance, CRR balance, etc.) in cases where interest rates are administered ;
iv) It is contractually pre-payable or withdrawal before the stated maturities.
Liquidity Risk
Risk of having insufficient liquid assets to meet the liabilities at a given time. The main liquidity concern of the ALM unit is the funding liquidity risk embedded in the balance sheet. The funding of long term mortgages and other securitized assets with short term liabilities (the maturity transformation process), has moved to centre stage with the contagion effect of the sub-prime debacle. Both industry and regulators failed to recognize the importance of funding and liquidity as contributors to the crisis and the dependence on short term funding created intrinsic flaws in the business model. Banks must assess the buoyancy of funding and liquidity sources through the ALM process.
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. The importance of liquidity transcends individual institutions, as liquidity shortfall in one institution can have repercussions on the entire system. Bank management should measure not only the liquidity positions of banks on an ongoing basis but also examine how liquidity requirements are likely to evolve under crisis scenarios.
Therefore liquidity has to be tracked through maturity or cash flow mismatches. For measuring and managing net funding requirements, the use of a maturity ladder and calculation of cumulative surplus or deficit of funds at selected maturity dates is adopted as a standard tool.
Forex Risk
Risk of having losses in foreign exchange assets and liabilities due to exchanges in exchange rates among multicurrency’s under consideration. The risk of an investment’s value changing due to changes in currency exchange rates. The risk that an investor will have to close out a long or short position in a foreign currency at a loss due to an adverse movement in exchange rates. Also known as “currency risk” or “exchange-rate risk”. Forex risk management cannot simply be left to chance.
Asset Liability Management Committee (ALCO)
Composition of ALCO Committee: (Structure can change from bank to bank)
• CEO, CFO, CRO
• Managing Directors
• Member : Vice President – F&A
• Convener : Vice President – F&A
• Quorum : Min : 3 Members
Scope :
The scope of ALCO Committee is as under.
• Liquidity Risk Management
• Pricing of assets and liabilities.
• Management of Market Risks
• Funding and Capital Planning
• Profit Planning
• Forecasting and analyzing ‘what if scenario’ and preparation of contingency plans.
The ALCO is a decision making unit responsible for integrated balance sheet management from risk-return perspective including the strategic management of interest rate and liquidity risks and reports to the Board of Directors. The business issues that an ALCO Committee would consider will, inter alia, include product pricing of deposits, if any, and advances, desired maturity profile and mix of the incremental assets and liabilities. The Committee would also articulate the current interest rate view of the company and base its decisions for future business strategy on this.
