ALM in Banks
ALM in Banks
Enterprise Risk management:
Committee of Sponsoring Organisations of the Treadway commission (COSO) issued “Enterprise Risk management- Integrated Framework” (ERM) to help Boards and Top management to understand an enterprise wide approach to Risk Management. The aim is to help organizations improve performance through better integration of Strategy, Risk Management, Control and Governance.
Implementation of ERM provides the opportunity to achieve a robust and holistic top-down view of key risks facing the organization and to manage those risks strategically to increase the likelihood that organizational objectives are achieved.
ERM is a process, affected by the entity’s Board of directors, management and other personnel, applied in strategy setting and across the enterprise, designed to identify potential events that may affect the entity.
All Risks in Bank falls under one of the three following major Risk categories:
• Credit Risk
• Operational Risk
• Market risk
Market Risk:
Market risk arises from adverse changes in the market variables such as Interest rate, Foreign exchange rate, equity price, commodity price etc., The Board of Directors should clearly articulate the policies, procedures, prudential risk limits, review mechanisms and reporting and auditing systems. The asset liability management committee (ALCO) should function as a top operational unit for managing the balance sheet with in performance/risk parameters laid down by the board. A Mid office consisting of Market risk management experts, Economists, Statisticians and general Bankers under ALCO should track the Market risk on real time. Mid office should be segregated from Front office.
Asset- Liability Management (ALM):
Asset-Liability risk is a leveraged form of Market risk. In case of Banks, their capital funds are very small compared to their assets and liabilities. As a result a small percentage change in value of assets or liabilities as a result of interest rate change may have devastating impact on capital funds.
Banks address this risk by structuring their assets to hedge their liabilities. This can be done per liability basis, matching a specific asset to support each liability. Alternatively it can be done across the Balance sheet. Under this approach, net exposure of Bank’s liability is determined, and a portfolio of assets is maintained which hedges this exposure.
All the transactions of the Bank revolve around raising and deploying the funds. Asset –Liability management is concerned with the strategic management of Balance sheet. This involves management of risks caused by changes in the interest rate, exchange rate and liquidity position of the bank. Credit risk and Contingency risk also by affecting the asset portion , forms part of ALM management.
Due to host of risks and their linkages, Risk Management approach to ALM should be multi dimensional. ALM techniques should address volume, mix, maturity, rate sensitivity, quality and liquidity of assets and liabilities as a whole.
RBI guidelines on ALM are primarily to address Liquidity Risk and Interest rate Risk. Liquidity is ability to fund a liability repayment, asset acquisition or funding off balance sheet item. A Bank has adequate liquidity when sufficient funds can be raised either by increasing liability or converting assets promptly at a reasonable cost or borrowing from money, capital or forex market. Analysis of liquidity is tracking of cash flow mismatches. For Liquidity Risk management, assets, Liabilities and off balance sheet items are grouped into different time buckets based on their future behavior based on assumptions and trend analysis. Additionally pre closure of deposits, prepayment of loans, and exercise of options also needs to be taken into account. Statement of structural liquidity is prepared from this.
Bank Boards have to fix prudential limits for this mismatch (Gap) . RBI stipulates that net cumulative mismatches in the first four buckets, i.e Next day, 2-7 days, 8-14 days and 15-28 days should not exceed 5%,10%,15%,20% of cumulative cash outflows in the respective time buckets . Further, prudential limits for Interbank borrowing, Purchased funds, Duration of liability and investment portfolio etc., also may be fixed by Boards to avoid liquidity crisis.
Since liquidity profile and cash flow depends upon market conditions, banks should evaluate liquidity profile under normal condition, Bank specific crisis and market crisis scenarios. A contingency plan to address bank specific crisis and market crisis situations to be put in place.
For managing Interest Rate risk, simple analytical technique for calculation of exposure is, Maturity Gap Analysis. Interest sensitive assets and liabilities are classified into different maturity buckets to arrive at Gap. Rate Sensitive Gap (RSG) enables the Bank to assess the impact of rate fluctuations on Net Interest Margin (NIM), NII and Market Value of Equity (MVE).For assets and liabilities lacking definite reprising intervals (SB,CA,CC/OD, embedded options) are assigned to buckets based on judgment , empirical studies and past experience of Banks.
Interest rate Risk takes various forms like Gap or mismatch Risk, Basis Risk, Embedded option risk, Yield Curve risk, Price Risk, Reinvestment Risk etc.,
The gap is used to measure interest rate sensitivity. A positive Gap indicates more RSA than RSL. The positive or Negative Gap is multiplied by assumed interest rate change to derive Earnings at Risk (EaR). EaR estimates how much earnings might be impacted by adverse movement in Interest rates. The changes in the interest rates can be estimated by past trends, forecasting etc., The Gap calculation can be augmented by information on average coupon on assets and liabilities in each time bucket.
More advanced approaches like Duration Gap analysis and simulation models are used by sophisticated banks.
Currency (Forex) risk is the risk of loss bank may suffer due to movement in exchange rate during the period bank has open position. In case of Currency Risk management, Banks have been given discretion to maintain overnight open position subject to maintenance of adequate capital. VaR is used for measuring the forex Risk. Prudential day light and overnight position limits are fixed by the bank. Segregation of Front, Mid and back office is another Forex risk management measure.
Enterprise Risk management:
Committee of Sponsoring Organisations of the Treadway commission (COSO) issued “Enterprise Risk management- Integrated Framework” (ERM) to help Boards and Top management to understand an enterprise wide approach to Risk Management. The aim is to help organizations improve performance through better integration of Strategy, Risk Management, Control and Governance.
Implementation of ERM provides the opportunity to achieve a robust and holistic top-down view of key risks facing the organization and to manage those risks strategically to increase the likelihood that organizational objectives are achieved.
ERM is a process, affected by the entity’s Board of directors, management and other personnel, applied in strategy setting and across the enterprise, designed to identify potential events that may affect the entity.
All Risks in Bank falls under one of the three following major Risk categories:
• Credit Risk
• Operational Risk
• Market risk
Market Risk:
Market risk arises from adverse changes in the market variables such as Interest rate, Foreign exchange rate, equity price, commodity price etc., The Board of Directors should clearly articulate the policies, procedures, prudential risk limits, review mechanisms and reporting and auditing systems. The asset liability management committee (ALCO) should function as a top operational unit for managing the balance sheet with in performance/risk parameters laid down by the board. A Mid office consisting of Market risk management experts, Economists, Statisticians and general Bankers under ALCO should track the Market risk on real time. Mid office should be segregated from Front office.
Asset- Liability Management (ALM):
Asset-Liability risk is a leveraged form of Market risk. In case of Banks, their capital funds are very small compared to their assets and liabilities. As a result a small percentage change in value of assets or liabilities as a result of interest rate change may have devastating impact on capital funds.
Banks address this risk by structuring their assets to hedge their liabilities. This can be done per liability basis, matching a specific asset to support each liability. Alternatively it can be done across the Balance sheet. Under this approach, net exposure of Bank’s liability is determined, and a portfolio of assets is maintained which hedges this exposure.
All the transactions of the Bank revolve around raising and deploying the funds. Asset –Liability management is concerned with the strategic management of Balance sheet. This involves management of risks caused by changes in the interest rate, exchange rate and liquidity position of the bank. Credit risk and Contingency risk also by affecting the asset portion , forms part of ALM management.
Due to host of risks and their linkages, Risk Management approach to ALM should be multi dimensional. ALM techniques should address volume, mix, maturity, rate sensitivity, quality and liquidity of assets and liabilities as a whole.
RBI guidelines on ALM are primarily to address Liquidity Risk and Interest rate Risk. Liquidity is ability to fund a liability repayment, asset acquisition or funding off balance sheet item. A Bank has adequate liquidity when sufficient funds can be raised either by increasing liability or converting assets promptly at a reasonable cost or borrowing from money, capital or forex market. Analysis of liquidity is tracking of cash flow mismatches. For Liquidity Risk management, assets, Liabilities and off balance sheet items are grouped into different time buckets based on their future behavior based on assumptions and trend analysis. Additionally pre closure of deposits, prepayment of loans, and exercise of options also needs to be taken into account. Statement of structural liquidity is prepared from this.
Bank Boards have to fix prudential limits for this mismatch (Gap) . RBI stipulates that net cumulative mismatches in the first four buckets, i.e Next day, 2-7 days, 8-14 days and 15-28 days should not exceed 5%,10%,15%,20% of cumulative cash outflows in the respective time buckets . Further, prudential limits for Interbank borrowing, Purchased funds, Duration of liability and investment portfolio etc., also may be fixed by Boards to avoid liquidity crisis.
Since liquidity profile and cash flow depends upon market conditions, banks should evaluate liquidity profile under normal condition, Bank specific crisis and market crisis scenarios. A contingency plan to address bank specific crisis and market crisis situations to be put in place.
For managing Interest Rate risk, simple analytical technique for calculation of exposure is, Maturity Gap Analysis. Interest sensitive assets and liabilities are classified into different maturity buckets to arrive at Gap. Rate Sensitive Gap (RSG) enables the Bank to assess the impact of rate fluctuations on Net Interest Margin (NIM), NII and Market Value of Equity (MVE).For assets and liabilities lacking definite reprising intervals (SB,CA,CC/OD, embedded options) are assigned to buckets based on judgment , empirical studies and past experience of Banks.
Interest rate Risk takes various forms like Gap or mismatch Risk, Basis Risk, Embedded option risk, Yield Curve risk, Price Risk, Reinvestment Risk etc.,
The gap is used to measure interest rate sensitivity. A positive Gap indicates more RSA than RSL. The positive or Negative Gap is multiplied by assumed interest rate change to derive Earnings at Risk (EaR). EaR estimates how much earnings might be impacted by adverse movement in Interest rates. The changes in the interest rates can be estimated by past trends, forecasting etc., The Gap calculation can be augmented by information on average coupon on assets and liabilities in each time bucket.
More advanced approaches like Duration Gap analysis and simulation models are used by sophisticated banks.
Currency (Forex) risk is the risk of loss bank may suffer due to movement in exchange rate during the period bank has open position. In case of Currency Risk management, Banks have been given discretion to maintain overnight open position subject to maintenance of adequate capital. VaR is used for measuring the forex Risk. Prudential day light and overnight position limits are fixed by the bank. Segregation of Front, Mid and back office is another Forex risk management measure.
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