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ALM and Fund Management

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ALM and Fund Management

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  1. ALM and Fund Management Jyoti Kumar Pandey Deputy General Manager & Member of Faculty College of Agricultural Banking, Pune College of Agricultural Banking, RBI, PUNE

  2. What is Banking • Section 5(b) defines banking ‘Accepting for the purpose of lending or investment of deposits or money repayable on demand or otherwise and withdrawable by cheque, draft, order or otherwise’ Risk taking is an inherent function of banking - Allan Greenspan College of Agricultural Banking, RBI, PUNE

  3. Banks get affected by • Actions of Central Banks • Actions of the Government • Domestic and International Disturbances • Inflation College of Agricultural Banking, RBI, PUNE

  4. Deregulation • Banks are now operating in a fairly deregulated environment and are required to determine on their own, interest rates on deposits and advances • Intense competition for business involving both the assets and liabilities together with increasing volatility in the interest rates has brought pressure on the management of banks to maintain a good balance among spreads College of Agricultural Banking, RBI, PUNE

  5. Risks Faced by Banks • Credit Risk • Market Risk • Liquidity Risk • Interest Rate Risk • Operational Risk College of Agricultural Banking, RBI, PUNE

  6. Effects of Risk Factors • Loss of Market Value • Loss of Reserves • Loss of stakeholders confidence College of Agricultural Banking, RBI, PUNE

  7. ALM • The ALM guidelines issued by RBI has been formulated to serve as a benchmark for banks which lack a formal ALM system • Those who already have their existing system may fine tune their information and reporting system College of Agricultural Banking, RBI, PUNE

  8. Purpose of ALM • Capture the maturity structure of the cash flows (inflows and outflows) in the Statement of Structural Liquidity • Tolerance levels for various maturities may be fixed by the bank keeping in view bank’s ALM profile, extent of stable deposit base, nature of cash flows etc. College of Agricultural Banking, RBI, PUNE

  9. ALM • ALM is about managing market risk and liquidity risk together • Capital market exposure of banks is small • Exchange risk is highly specialized • Hence ALM is an integrated risk management approach for managing liquidity risk, interest rate risk College of Agricultural Banking, RBI, PUNE

  10. The problem of mismatch • Mismatches in maturity • Mismatches in interest rate • How does bank makes the spread? • Borrow short and lend long and keep the spread • Maturity mismatch is the basis of profitability • Risk management does not eliminate mismatch – merely manages them College of Agricultural Banking, RBI, PUNE

  11. The problem of mismatch • Interest Rate Risk  Affects profitability • Liquidity Risk  May lead to liquidation • General Strategy • Eliminate Liquidity Risk (not the mismatch) • Manage Interest Rate Risk • Consciously create gaps College of Agricultural Banking, RBI, PUNE

  12. Asset Liability Transformation • Banks are exposed to credit and market risks in view of the asset-liability transformation • With liberalisation, banks’ operations have become complex and large , requiring strategic management College of Agricultural Banking, RBI, PUNE

  13. ALM Pillars • ALM Information Systems • ALM Organisation • ALM Process Applicable to Scheduled UCBs and Tier II UCBs For Tier II UCBs – effective date is December 2008 College of Agricultural Banking, RBI, PUNE

  14. ALM Pillars (Contd.) • ALM Information systems • MIS • Information availability • Accuracy • Adequacy • Expediency College of Agricultural Banking, RBI, PUNE

  15. ALM Pillars (Contd.) • ALM Organisation • Structure and responsibilities • Level of top management involvement College of Agricultural Banking, RBI, PUNE

  16. ALM Pillars (Contd.) • ALM Process • Risk Parameters • Risk Identification • Risk Measurement • Risk Management • Risk Policies and Procedures, prudential limits and auditing, reporting and review College of Agricultural Banking, RBI, PUNE

  17. ALM Information Systems • ALM framework built on sound methodology with necessary information system back-up • ALM to be supported by management philosophy and clearly states risk policies and procedures / prudential limits • Banks may utlilise ‘Gap Analysis’ or ‘Simulation’ • Important to have availability of timely, adequate and accurate information College of Agricultural Banking, RBI, PUNE

  18. ALM Information Systems (Contd.) • ALM Data could be developed by following approach, in case UCBs do not have requisite information • Analyse behaviour of asset and liability products in sample branches that account for significant business (60-70 per cent) • Based on this make rational assumption for the other branches UCBs have limited area of operations and hence it would be easier for them to make such assumptions and better access to data College of Agricultural Banking, RBI, PUNE

  19. ALM Organisation • Board should have overall responsibility for management of risk • Board should decide risk management policy and procedure, set prudential limits, auditing, reporting and review mechanism in respect of liquidity, interest rate and forex risk • ALCO • Consisiting of bank’s senior management including CEO • Responsible for adherence to the polices and limits set by Board • Responsible for deciding business strategies (on asset liability side) in line with bank’s business and risk objectives • ALM Support Group • Consisting of operating staff • Responsible for analysing, monitoring and reporting risk profiles to ALCO • Prepare forecasts showing effects of various possible changes in market conditions affecting balance sheet and suggesting action to adhere to bank’s internal limits College of Agricultural Banking, RBI, PUNE

  20. ALM Organisation (Contd.) • ALCO decision making unit responsible for • Balance Sheet planning from risk-return perspective which includes management of liquidity, interest rate and forex risks • Pricing of deposits and advances, desired maturity profile etc. • Monitoring the risk levels of the bank • Review of the results and progress of implementation of decisions made in previous meeting • Future business strategies based on bank’s current view on interest rates • To decide on source and mix of liabilities or sale of assets • To develop future direction of interest rate movements • To decide on funding mix between fixed and floating rate funds, wholesale vs. retails deposits, short term vs. long term deposits etc. College of Agricultural Banking, RBI, PUNE

  21. ALM Organisation (Contd.) • ALCO size would be dependent on the size of the UCB • May comprise of • CEO or Secretary • Chief of Investment / Treasury including those of forex, credit, planning etc. • Head of IT if a separate division exists • UCBs may at their discretion may have Sub-committees and Support Groups College of Agricultural Banking, RBI, PUNE

  22. ALM Process • Scope is • Liquidity Risk Management • Interest Rate Risk Management • Trading (Price) risk Management • Funding and Capital Management • Profit Planning and business Projections UCBs, generally, are not exposed to forex risk College of Agricultural Banking, RBI, PUNE

  23. ALM • Liquidity Risk • Interest Rate Risk College of Agricultural Banking, RBI, PUNE

  24. Liquidity Risk • Arising due to • Over extension of credit • High level of NPAs • Poor asset quality • Mismanagement • Hot Money • Non recognition of embedded option risk • Reliance on few wholesale depositors • Large undrawn loan commitments • Lack of appropriate liquidity policy and contingent plan College of Agricultural Banking, RBI, PUNE

  25. Liquidity vs. Earnings • Bank must be in a position to:- • Balance their need for liquidity with their need for earnings • More liquid assets tend to provide lower return than do less liquid assets College of Agricultural Banking, RBI, PUNE

  26. Assessing Liquidity Position • Assessing a bank’s liquidity position can be challenging • An adequate position for one bank may not be sufficient for another • A position considered adequate for a bank in one time period may not be so in another • BANK SPECIFIC & DYNAMIC College of Agricultural Banking, RBI, PUNE

  27. Liquidity risk-Manifestation • Funding risk • Need to replace net outflows due to unanticipated withdrawal/non-renewal of deposits • Time Risk • Need to compensate for non-receipt of expected inflows of funds-performing assets turning into non-performing assets College of Agricultural Banking, RBI, PUNE

  28. Liquidity Risk - Measurement • Two methods are employed: • Stock approach - Employing ratios • Flow approach - Time bucket analysis College of Agricultural Banking, RBI, PUNE

  29. Liquidity Risk - Measurement • Liquidity Ratios • Volatile Liability Dependence Ratio • Volatile Liabilities minus Temporary Investments to Earning Assets net of Temporary Investments • Shows the extent to which bank’s reliance on volatile funds to support Long Term assets • where volatile liabilities represent wholesale deposits which are market sensitive and temporary investments are those maturing within one year and those investments which are held in the trading book and are readily sold in the market • Growth in Core Deposits to growth in assets • Higher the ratio the better College of Agricultural Banking, RBI, PUNE

  30. Liquidity Risk – Measurement (Contd.) • Purchased Funds to Total Assets • where purchased funds include the entire inter-bank and other money market borrowings, including Certificate of Deposits and institutional deposits • Loan Losses to Net Loans • Loans to core deposits College of Agricultural Banking, RBI, PUNE

  31. Liquidity Risk – Measurement (Contd.) • Does not lead to proper assessment of liquidity gaps due to: • Illiquidity of liquid assets • Their ready marketability • Difficulty to convert easily into liquid cash with least loss of value from the previously quoted market rates College of Agricultural Banking, RBI, PUNE

  32. Liquid Assets to Total Assets • Liquid Assets to Total Assets • Show the percentage of liquid assets in the asset structure of the bank - 18-20% • Liquid assets generally are cash balances with RBI + balances with other banks + investments available for sale + money market instruments College of Agricultural Banking, RBI, PUNE

  33. Liquid Assets to Total Deposits • Liquid Assets to Total Deposits • This ratio indicates extent of liquidity maintained by a bank for meeting the demand made by the depositors-Sometimes taken as a measure of bank liquidity-20-22% College of Agricultural Banking, RBI, PUNE

  34. Loans to Deposits • Loans to Deposits • Loans to deposits ratio indicates the degree to which the bank has already used up its available resources to accommodate the credit needs of the customers • A high loan deposit ratio indicates that a bank will have comparatively low liquidity College of Agricultural Banking, RBI, PUNE

  35. Loans to Assets • Loans to Assets • This ratio indicates the percentage of illiquid assets to total assets • A rise in this ratio would indicate lower liquidity College of Agricultural Banking, RBI, PUNE

  36. Loans to Core Deposits • Loans to Core Deposits • Those deposits which are not subject to any large volatility • Average level of previous years deposit is generally taken as core deposits • This ratio helps in assessing level of deployment of core portion of deposits College of Agricultural Banking, RBI, PUNE

  37. Loans to Investments • Loans to Investments • While loans provide higher returns compared to investments, these suffer from credit risk and are more illiquid than investments • A proper mix of loans and investments keeping in view liquidity and yield considerations need to be fixed College of Agricultural Banking, RBI, PUNE

  38. Cash Flow Approach • Preparing a structural liquidity by taking into account balance sheet on particular date and place in maturity ladder according to time buckets • Identify the liquidity needs - to evolve methods to meet it • Negative gaps in individual time buckets indicate the need. The need could be controlled by • prudential limits • as also by regulating the basis of business structure/financial flexibility of banks • Regulatory Limit of 20% on outflows in first two time buckets College of Agricultural Banking, RBI, PUNE

  39. RBI Guidelines on Liquidity Risk • Methodology prescribed in ALM System- Structural Liquidity Statement & Dynamic Liquidity Ladder are simple • Need to make assumptions and trend analysis- Behavioural maturity analysis • Variance Analysis at least once in six months and assumptions fine-tuned • Track the impact of exercise of options & potential liquidity needs • Cap on inter-bank borrowings & Call money College of Agricultural Banking, RBI, PUNE

  40. Structural Liquidity Statement – Sch. UCBs • SSL Layout Circular Sept. 17, 2008 for Scheduled UCBs More granular approach adopted – by splitting first bucket of 1 – 14 days in SSL into Next Day, 2-7 days and 8 – 14 days Net cumulative negative mismatches during the Next Day, 2 – 7 days, 8 – 14 days and 15 – 28 days bucket should not exceed 5%, 10%, 15% and 20% of the cumulative cash outflows in the respective buckets Banks may undertake dynamic liquidity management and should prepare the SSL on daily basis to Top Management / ALCO SSL may be reported to RBI at fortnightly intervals within 10 days of the reporting Friday Revised format would be applicable from January 01, 2009 UCBs in Tier II are also covered Scheduled UCBs to report structural liquidity position and interest rate sensitivity to RBI as part of OSS data College of Agricultural Banking, RBI, PUNE

  41. Structural Liquidity Statement – Sch. UCBs (Contd.) College of Agricultural Banking, RBI, PUNE

  42. Structural Liquidity Statement – Sch. UCBs (Contd.) College of Agricultural Banking, RBI, PUNE

  43. Structural Liquidity Statement – Sch. UCBs (Contd.) College of Agricultural Banking, RBI, PUNE

  44. Structural Liquidity Statement – Sch. UCBs (Contd.) • Liability on account of event cash flows – CRR / SLR shortfall, wage settlement and any other contingency under respective maturity bands • All overdue liabilities in Day 1, 2 – 7 days and 8 – 14 days bucket based on behavioral estimates • Interest and installments from advances and investments which are due for less than one month – 1-6 months time band • Interest and installments from advances and investments which are over due for less than one month may be placed in Day 1, 2-7 days and 8 – 14 days based on behavioral pattern. Further, interest and installments due (before classification as NPAs may be placed in 29 days – 3 months bucket if the earlier receivables remain uncollected College of Agricultural Banking, RBI, PUNE

  45. Liquidity Risk Management for Tier 1 UCBs • Basic guidelines for liquidity management issued on September 17, 2008 • Banks advised to prepare • Statement of Structural Liquidity and • Statement of Short Term Dynamic Liquidity • To be prepared as on the last reporting Friday of March / June / September / December and submit to the Board within one month from the last reporting Friday • First such submission to be made to the Board as on last reporting Friday of December 2008 College of Agricultural Banking, RBI, PUNE

  46. Liquidity Risk Management for Tier 1 UCBs (contd.) • Maturity profile of SSL into 8 buckets • 1-14 days • 15-28 days • 29 and up to 3 months • Over 3months and up to 6 months • Over 6 months and up to 1 year • Over 1 year and up to 3 years • Over 3 years and up to 5 years • Over 5 years • Mismatches (negative gaps) during 1-14 and 15-28 days time bands in normal course should not exceed 20 % of the cash flows in each time band College of Agricultural Banking, RBI, PUNE

  47. Liquidity Risk Management for Tier 1 UCBs (contd.) • Short Term Dynamic Liquidity Statement • 1-14 days • 15-28 days • 29-90 days • STDL required for securities in the trading book • SLR investments / securities are generally not very liquid and lack depth and are therefore shown in the residual maturity bands corresponding to residual maturity College of Agricultural Banking, RBI, PUNE

  48. Liquidity Risk Management for Tier 1 UCBs (contd.) • Holding period not to exceed 90 days • Cut loss limit is prescribed • Defeasance periods are prescribed – Time taken to liquidate the position on the basis of liquidity in the secondary market are prescribed • Marking to market on a weekly basis College of Agricultural Banking, RBI, PUNE

  49. Trading Book • Maintained distinctly from those required for complying with Statutory Reserve Requirements • Subject to preconditions • Composition and volume clearly defined • Maximum maturity / Duration of the portfolio restricted • Holding period not exceeding 90 days • Cut Loss prescribed • Marked to market on a weekly basis College of Agricultural Banking, RBI, PUNE

  50. Maturity Profile Liquidity for Tier 1 UCBs College of Agricultural Banking, RBI, PUNE