Asset Liability is one of the core risks of a bank. So far, managing the asset liability means managing a core risk of a bank. The asset liability is managed by a committee that we call ALCO (Asset Liability Management Committee). The committee is formed with the senior management people of a bank.
The main responsibilities of ALCO are to look after the financial market activities, manage liquidity and interest rate risks, understand the market position and competition, etc. In carrying out its responsibilities, the ALCO holds periodical meetings and regularly reviews the decisions of the meetings giving due consideration to the market situation.
Managing the risks profitably is a great challenge for the ALCO, let alone the risk and its management process under asset liability.
A liquidity risk occurs, when a bank cannot meet short-term debt obligations. This usually occurs due to the inability to convert a security or hard asset to cash without a loss of capital and/or income in the process. For managing the liquidity risk the bank has to consider the asset, liability and capital structure. In the asset structure a bank has to consider the nature of business, tenure of lending, interest rate structure (fixed/floating), pattern of repayment (regular installment or bullet payment) and Cash-Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) requirements.
On the other hand, for liability structure a bank has to consider grouping of liabilities into two major categories according to the maturity, namely, long-term and short-term, pricing option, exchange rate fluctuation in case of foreign currency transactions and early repayment option. The capital structure includes Equity, Preference share, long-term Bond under both clean and securitisation arrangement, etc. Here the bank has to consider the regulatory framework, favourable gearing ratio, capital adequacy ratio and value of the organisation.
The interest rate risk arises from fluctuation of interest rates which affect the spread between the deposit and lending rates. We may also say that the interest rate risk arises due to a change in the overall market interest rate structure both for borrowing and lending.
The prepayment risk arises due to early repayment either partial or the entire loan portfolio, which results in loss of interest income.
On the other hand, the credit risk can be classified into two categories: default risk and credit spread risk.
The reinvestment risk is that the amount of prepaid loans will be reinvested at less than the existing rate. A declining interest rate environment induces borrowers to make prepayment and forces banks to invest at comparatively low rates.
For mitigating the risk profitably, the bank has to take some policies. The Management Committee of the bank should set out the policy and an annual review should be made taking into consideration the changes in the Balance Sheet and market dynamics as follows:
Loan to Fund Ratio - The Loan to Fund Ratio = Loan & Advances/ (Capital + Reserve + Deposit + Bank Borrowing+ Bond + Other). The Loan to Fund ratio should not exceed 95 per cent. Any excess lending must be supported by confirmed sources of fund.
Liquidity Contingency Plan - A liquidity contingency plan needs to be approved by ALCO. A contingency plan needs to be prepared keeping in mind that enough liquidity is available to meet the fund requirements in a liquidity crisis situation. An annual review of the contingency planning should be made. The contingency plan should be backed up by the first line of defence like, firm line of credit (SOD) and second line of defence like, short-term loan, commercial paper, bill discounting facility, etc. A contingency plan should include fund requirements for Letters of Credit (LCs), Guarantee, etc. This contingency plan should be made for six months.
Maturity-wise cash flow statement - The cash flow statement should be framed in such a way that it gives information to management for GAP analysis. A cash flow statement should be made for different maturity periods viz., within seven days, two weeks, 1-12 months, above one year-three years, above three years-five years, above five years-10 years, above 10 years to 15 years, above 15 years-20 years, etc., as the situation demands.
Maturity-wise interest rate profile - The maturity-wise interest rate profile should be made both for lending and borrowing products so that the management can know its effective lending and borrowing rates at any particular point of time. This would help make Spread Analysis.
Term of lending vs. borrowing - The management should classify its assets and liabilities according to their maturity tenure viz., within seven days, two weeks, 1-12 months, above one year-three years, above three years-five years, above five years-10 years, above 10 years to 15 years, above 15 years-20 years, etc., as the situation demands.
Compliance - Internal as well as statutory compliances must be strictly followed. Keeping the market scenario and regulatory framework in mind, the internal compliance procedure should be made flexible enough to adopt any required change immediately to meet the changing situation.
Finally, an asset liability information system has to be designed. The information system should be designed in such a way that it could provide reliable information time to time to the ALCO. In such a way the bank can manage their asset and liability profitably.
The writer is a banker.
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