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Asset And Liability Management

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Shreeya Mehta

on 20 September 2013

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Transcript of Asset And Liability Management


Asset And Liability Management
Initially pioneered by Anglo-Saxon financial institutions during 1970s as interest rates became increasingly volatile, asset and liability management (often abbreviated ALM) is the practice of managing risks that arise due to mismatches between the assets and liabilities.

The process is at the crossroads between risk management and strategic planning as its not just offering solution to mitigate or hedge the risks arising from the interaction of assets and liabilities but is conducting the bank from a long-term perspective (success in the process of maximizing assets to meet complex liabilities may increase profitability)
As an echo to the deficit of funds resulting from gaps between assets and liabilities the bank has also to address its funding requirement through an effective, robust and stable funding model.
Constraints to take into account

Obtaining funds at reasonnable costs
Fostering funding diversification in the sources and tenor of funding in the short, medium to long-term (funding mix process)
Adapting the maturities of liabilities cash-flow in order to match with funds uses
Putting a operative plan for the normal daily operations and ongoing business activities

This plan needs to embrace all available funding sources and requires an integrated approach with the strategic business planning process. The objective is to provide realistic projection of funding future under various set of assumptions. This strategy includes :
Asset And Liability Management
Liquidity Risk Management
The role of the bank in the context of the maturity transformation that occurs in the banking book (as traditional activity of the bank is to borrow short and lend long) lets inherently the institution vulnerable to liquidity risk and can even conduct to the so-call risk of 'run of the bank' as depositors, investors or insurance policy holders can withdraw their funds/ seek for cash in their financial claims and thus impacting current and future cash-flow and collateral needs of the bank (risk appeared if the bank is unable to meet in good conditions these obligations as they come due).
As the landscape of the financial services industry becomes increasingly competitive,
with rising costs of intermediation due to higher capital requirements and deposit
insurance, financial institutions face a loss of spread income. In order to enhance the
loss in profitability due to such developments, financial institutions may be forced
to deliberately mismatch asset/liability maturities in order to generate
higher spreads.
ALM is a systematic approach that attempts to provide a degree of protection to
the risk arising out of the asset/liability mismatch. ALM consists of a framework
to define, measure, monitor, modify and manage liquidity and interest rate risk. It
is not always possible for financial institutions to restructure the asset and liability
mix directly to manage asset/liability GAPs. Hence, off-balance sheet strategies
such as interest rate swaps, options, futures, caps, floors, forward rate agreements,
swaptions, and so on, can be used to create synthetic hedges to manage asset/
liability GAPs
In the 1940's and 1950's there was an abundance of funds in banks in the form of demand and saving deposits . Hence,the focus then was mainly on asset management

But as the availablity of low cost funds started to decline, liability management became the focus of bank management efforts

In the 1980's , Volatility of interest rates in USA and Europe caused the focus to broaden to include the issue of interest rate risk. ALM begsn to extend beyond the bank treasury to cover the loans and deposit functions

Banks Started to concentrate more on the management of both slides of the balance sheet
3 Tools Used by banks for ALM


Building An ALM POLICY
As in all operational areas, ALM must be guided by a formal policy and must address:

Limits on the maximum size of major asset/ liability categories
Balance sheet mix : in order to follow the old adage 'Don't pull all your eggs in one basket'
Limits on the mix of balance sheet assets (loans by credit category, financial instruments...) considering levels of risk and return and thus guided by annual planning targets, lending license constraints and regulatory restrictions on investments.
Limits on the mix of balance sheet liabilities such as deposits and other types of funding (all sources of funding are expressed as a % of total assets with the objective to offer comparability and correlate by term and pricing to the mix of assets held) considering the differential costs and volatility of these types of funds
Policy limits have to be realistic :based on historical trend analysis and comparable to the peers or the market
Correlating maturities and terms
Controlling liquidity position and set limits in terms of ratios and projected net cash-flows, analyze and test alternative sources of liquidity
Managing Gaps
Managing gaps

The objective is to measure the direction and extent of asset-liability mismatch through the funding or maturity gap. This aspect of ALM stresses the importance of balancing maturities as well as cash-flows or interest rates for a particular set time horizon.

For the management of interest rate risk it may take the form of matching the maturities and interest rates of loans and investments with the maturities and interest rates of deposit, equity and external credit in order to maintain adequate profitability. In other words, it is the management of the spread between interest rate sensitive assets and interest rate sensitive liabilities..

Gap analysis suffers from only covering future gap direction of current existing exposures and exercice of options (i.e.: prepayments) at different point in time. Dynamic gap analysis enlarges the perimeter for a specific asset by including 'what if' scenarios on making assumptions on new volumes, (changes in the business activity, future path of interest rate, changes in pricing, shape of yield curve, new prepayments transactions, what its forecast gap positions will look like if entering into an hedge transaction...)
Liquidity Risk
The risk stemming from the lack of marketability of an investment that cannot be bought or sold quickly enough to prevent or minimize a loss. Liquidity risk is typically reflected in unusually wide bid-ask spreads or large price movements (especially to the downside). The rule of thumb is that the smaller the size of the security or its issuer, the larger the liquidity risk

Types of liquidity risk

Market liquidity – An asset cannot be sold due to lack of liquidity in the market – essentially a sub-set of market risk.[1] This can be accounted for by:

Widening bid/offer spread
Making explicit liquidity reserves
Lengthening holding period for VaR calculations

Funding liquidity – Risk that liabilities:

Cannot be met when they fall due
Can only be met at an uneconomic price
Can be name-specific or systemic

The increased capital lows from the different nations following deregulation have contributed to increase in the volume of transcation

Dealing in different currencies brings oppurtunities as well as risk

To prevent this banks have been setting up overnight limits and undertaking active day time trading

Value at risk approach to be used to measured the risk associated with forward exposures. Value at Risk estimated probability of portfolio losses based on the statistical analysis of historical price trends and volatilities
Interest Rate Risk
Interest Rate risk is the exposure of a bank's financial conditions to adverse movements of interest rate

Though this is normal part of banking business, excessive interest rate risk can pose a significant threat to a bank's earnings and capital base

Changes in interest rates also affects the underlying values of the bank's assets ,liabilities and off balance sheet item

Interest rate risk refers to volatilty in Net interest income (NII) or variations in Net Interest Margin (NIM)


The asset contribution to funding requirement depends on the bank ability to convert easily its assets to cash without loss.

Cash-flows : as the primary source of asset side funding, occur when investments mature or through amortization of loans (periodic principal and interest cash-flows) and mortgage-backed securities
Pledging of assets: in order to secure borrowings or line commitments. This practice induces a close management of these assets hold as collateral
Liquidation of assets or sale of subsidiaries or lines of business (other form of shortening of assets can be also to reduce new loans origination)
Securitization of assets as the bank originates loans with the intent to transform into pools of loans and selling them to investors

Retail funding

From customers and small businesses and seen as stable sources with poor sensitivity level to market interest rates and bank's financial conditions.

Deposit account
Transaction accounts
Savings accounts
Public deposit

Assessment of possible funding sources
Main characteristicsConcentrations level between funding sources
Sensitivity to interest-rate and credit risk volatility
Ability and speed to renew or replace the funding source at favorable terms (evaluation of the possibility to lengthening its maturity for liability source)
For borrowed funds, documentation of a plan defining repayment of the funds and terms including call features, prepayment penalties, debt covenants...
Possible early redemption option of the source
Diversification of sources, tenors, investors base and types, currencies and to collateralization requirements (with limits by counterparty, secured versus unsecured level of the market funding, instrument types, securitization vehicles, geographic market and investor types)
The objective of asset and liability management is to develop and implement policies and processes to assist in:

identifying, acquiring, accurately valuing, managing and disposing of assets, and ensuring those assets are put to optimal use for purposes consistent with site objectives
identifying, incurring, accurately valuing, and meeting liabilities and ensuring those liabilities are only incurred for purposes consistent with agency objectives
The scope of the ALM function to a larger extent covers the hereafter processes :

1) Liquidity risk : the current and prospective risk arising when the bank has the inability to meet its obligation as they come due without adversely affecting the bank's financial conditions. In ALM perspective, the focus is on the funding liquidity risk of the bank meaning it's ability to meet its current and future cash-flow obligations and collateral needs, both expected and unexpected.
2) Interest rate risk : The risk of losses resulting from movements in interest rates and their impact on future cash-flows. Generally because a bank may have a disproportionate amount of fixed or variable rates instruments on either side of the balance-sheet. One of the primary causes are mismatches in terms of a bank deposits and loans.
3) Currency risk management: The risk of losses resulting from movements in exchanges rates.To the extent that cash-flows assets and liabilities are denominated in different currencies.
Philippine Premium Deposit Funds
Premium tax in the Philippines is set at 5%
Significant disadvantage vs mutual funds
Solution was interest-bearing premium deposits
AL risk arose because

Insurers were careless with caveating policy illustrations

The rate was set at 12% pa across
the market, and held for many
A ‘policyholder reasonable expectation’ had been created
In 2000, yields on long-term Philippine government bonds fell to
9% pa. The risk was crystallised.
Provincial Finance
Small New Zealand finance company
Borrowed short from retail investors, lent long (mainly personal
loans for the purchase of cars)
Went into receivership when it failed to make interest and
prinicipal payments to investors.
At the time of the receivership, Provincial had assets of
NZ$352m and liabilities of NZ$331
m (i.e. net assets of NZ$21m)
During the receivership, investors have received back 92.5% of
their investment
If pending legal action is successful, investors may receive the
remaining 7.5%
Based on Jim Harvey's speech structures
ALM Organization

Static Gap Measurement Techniques
Funding Management
Asset Based Funding Source
Liability And Equity Funding Sources
Putting A Operative Plan For Normal Daily Business Activites
Funding requirement liability sensitivity table
Currency Risk
Gap Report

The Gap Report should be generated by grouping rate sensitive liabilities, assets and off-
balance sheet positions into time buckets according to residual maturity or next repricing period,
whichever is earlier. The difficult task in Gap analysis is determining rate sensitivity. All
investments, advances, deposits, borrowings, purchased funds etc. that mature/reprice within a
specified timeframe are interest rate sensitiv

The interest rates on
advances could be repriced any number of occasions, corresponding to the changes in PLR. The
Gaps may be identified in the following time buckets:
upto 1 month
Over one month and upto 3 months
Over 3 months and upto 6 months
Over 6 months and upto 12 months
Over 1 year and upto 3 years
Over 3 years and upto 5 years
Over 5 years
Barkha Gangwani
Usage of real Time information system to gather the information about the maturity and behaviour of loans and advances made by all other branches of bank

1)analysing the behaviour of asset and liability products in the top branches as they account for significant business
2)then making rational assumptions about the way in which assets ad liabilites would behave in other branches
3)the data and assumptions can then be refined over the time as the bank management gain experience

1)ALCO consisting of the banks senior management (includingCEO) should be responsible for ensuring adherence to the limits set by the board
2)Is responsible for balance sheet planning from risk-return perspective including the strategic management of interest rate and liquidity risks
3)The role of ALCO includes products pricing or both deposits and advances desired maturity profile of the incremental assets and liabilities
4) It should review the results of and progess in implementation of the decision made in the previou meetings


An operational risk is defined as a risk incurred by an organisation's internal activities.

Operational risk is the broad discipline focusing on the risks arising from the people, systems and processes through which a company operates. It can also include other classes of risk, such as fraud, legal risks, physical or environmental risks.

A widely used definition of operational risk is the one contained in the Basel II regulations. This definition states that operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events.[1]

Operational risk management differs from other types of risk, because it is not used to generate profit (e.g. credit risk is exploited by lending institutions to create profit, market risk is exploited by traders and fund managers, and insurance risk is exploited by insurers). They all however manage operational risk to keep losses within their risk appetite - the amount of risk they are prepared to accept in pursuit of their objectives
Credit risk
You lend somebody money, and they don’t give it back
In practice, it’s a little more complex

Issuers have different degrees of cr
edit risk, based on their ability to

Credit risk is assessed by the ma
rket, through the yields demanded
on debt issues, and by the rating agencies

Credit risks may differ based on
term, currency, ranking, legal
structure, insurance

Even issues in default have diff
ering pay-back probabilities and
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