Executive Summary: Assets and Liability Management by Banks in India

Assets and Liability Management by Banks in India
EXECUTIVE SUMMARY
Asset-liability management refers to the overall control of the

composition of balance sheet accounts to attain key objectives. These
key objectives are to generate optimum levels of quality earnings and
to maintain adequate liquidity to meet both predicted and unexpected
cash needs. The increasing volatility in funding sources and market
rates resulting from the removal of interest rate limitations and rapid
fluctuations in the economy have made effective funds management
essential to successful operations.
The main objective of ALM is Liquidity Risk Management and
Interest Rate Risk Management. These two aspects is key input in
business planning process of a bank. Liquidity risk and Interest Rate
risk can be measured through various tools. To measure liquidity risk
stock approach and flow approach is used while Gap analysis and
Value at Risk are important tools to measure interest risk.
To achieve the above objective of ALM “Asset and liability
management Committee (ALCO)” is delegated the responsibility from
the risk management committee. ALCO manages the market risk
faced by the bank while ensuring adequacy of capital for the various
market risk related activities/products of the bank. ALCO also frames
the liquidity policies and manage interest rate risk in the Banking book
and in the trading book. ALCO frames the policies according to the
guidelines given by RBI.
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INDEX (Put in the Table form)

CONTENTS PAGENO.
1. Introduction 01
a. Meaning 01
b. Why ALM 01
2. ALM – Three pillars 02
a. ALM Information System 03
b. ALM Organization 04
c. ALM Process 05
3. Scope and Objective of ALM 06
4. Liquidity Risk Management 09
5. Interest Risk Management 14
a. Mis-Match Risk 14
b. Basis Risk 16
c. Embedded Option Risk 16
d. Yield Curve Risk 17
e. Price Risk 17
6. Management of Interest Risk in Banking book 19
a. Earnings perspective 19
b. Economic value perspective 22
7. Value At Risk (VAR) 23
8. RBI Guidelines – It’s Implementation 32
9. Conclusion 35
10. Bibliography 35
11. Appendix & Annexures 36
a. Appendix I 36
b. Appendix II 41
c. Annexure I 46
d. Annexure III 51
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1. INTRODUCTION:
1a. Meaning
Over the last few years the Indian financial markets have witnessed wide
ranging changes at fast pace. Intense competition for business involving
both the assets and liabilities, together with increasing volatility in the
domestic interest rates as well as foreign exchange rates, has brought
pressure on the management of banks to maintain a good balance among
spreads, profitability and long-term viability. These pressures call for
structured and comprehensive measures and not just ad hoc action. The
Management of banks has to base their business decisions on a dynamic
and integrated risk management system and process, driven by corporate
strategy. Banks are exposed to several major risks in the course of their
business - credit risk, interest rate risk, foreign exchange risk, equity /
commodity price risk, liquidity risk and operational risks. Asset-liability
management refers to the overall control of the composition of balance
sheet accounts to attain key objectives. These key objectives are to
generate optimum levels of quality earnings and to maintain adequate
liquidity to meet both predicted and unexpected cash needs. The
increasing volatility in funding sources and market rates resulting from
the removal of interest rate limitations and rapid fluctuations in the
economy have made effective funds management essential to successful
operations.
1b. Why ALM?

In the normal course, banks are exposed to credit and market risks in
view of the asset-liability transformation. With liberalisation in Indian
financial markets over the last few years and growing integration of
domestic markets and with external markets, the risks associated with
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banks' operations have become complex and large, requiring strategic

management. Banks are now operating in a fairly deregulated
environment and are required to determine on their own, interest rates on
deposits and advance in both domestic and foreign currencies on a
dynamic basis. The interest rates on banks' investments in government
and other securities are also now market related. Intense competition for
business involving both the assets and liabilities, together with increasing
volatility in the domestic interest rates as well as foreign exchange rates,
has brought pressure on the management of banks to maintain a good
balance among spreads, profitability and long-term viability. Imprudent
liquidity management can put banks' earnings and reputation at great risk.
These pressures call for structured and comprehensive measures and not
just ad hoc action. The Management of banks has to base their business
decisions on a dynamic and integrated risk management system and
process, driven by corporate strategy. Banks are exposed to several major
risks in the course of their business - credit risk, interest rate risk, foreign
exchange risk, equity / commodity price risk , liquidity risk and
operational risk. It is, therefore, important that banks introduce effective
risk management systems that address the issues related to interest rate,
currency and liquidity risks.
"Banks need to address these risks in a structured manner by

upgrading their risk management and adopting more comprehensive
practicecomprehensive practice - Asset-Liability Management (ALM) o.
ALM provides a comprehensive and dynamic framework for measuring,
monitoring and managing liquidity, interest rate, foreign exchange and
equity and commodity price risks of a bank that needs to be closely
integrated with the banks' business strategy. It involves assessment of
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various types of risks and altering the asset-liability portfolio in a

dynamic way in order to manage risks
2. The ALM process rests on three pillars:

a. ALM information systems
=> Management Information System
=> Information availability, accuracy, adequacy and expediency
b. ALM organization
=> Structure and responsibilities
=> Level of top management involvement
c. ALM process
=> Risk parameters
=> Risk identification
=> Risk measurement
=> Risk management
=> Risk policies and tolerance levels.
2a. ALM Information Systems

Information is the key to the ALM process. Considering the large
network of branches and the lack of an adequate system to collect
information required for ALM which analyses information on the basis of
residual maturity and behavioural pattern it will take time for banks in the
present state to get the requisite information. The problem of ALM needs
to be addressed by following an ABC approach i.e. analysing the
behaviour of asset and liability products in the top branches accounting
for significant business and then making rational assumptions about the
way in which assets and liabilities would behave in other branches. In
respect of foreign exchange, investment portfolio and money market
operations, in view of the centralised nature of the functions, it would be
much easier to collect reliable information. The data and assumptions can
then be refined over time as the bank management gain experience of
conducting business within an ALM framework. The spread of
computerization will also help banks in accessing data.
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2b. ALM Organization

The Board should have overall responsibility for management of risks
and should decide the risk management policy of the bank and set limits
for liquidity, interest rate, foreign exchange and equity price risks.
The Asset - Liability Committee (ALCO) consisting of the bank's senior
management including CEO should be responsible for ensuring
adherence to the limits set by the Board as well as for deciding the
business strategy of the bank (on the assets and liabilities sides) in line
with the bank's budget and decided risk management objectives.
The ALM desk consisting of operating staff should be responsible for
analysing, monitoring and reporting the risk profiles to the ALCO. The
staff should also prepare forecasts (simulations) showing the effects of
various possible changes in market conditions related to the balance sheet
and recommend the action needed to adhere to bank's internal limits.
The ALCO is a decision making unit responsible for balance sheet
planning from risk -return perspective including the strategic
management of interest rate and liquidity risks. Each bank will have to
decide on the role of its ALCO, its responsibility as also the decisions to
be taken by it. The business and risk management strategy of the bank
should ensure that the bank operates within the limits / parameters set by
the Board. The business issues that an ALCO would consider, inter alia,
will include product pricing for both deposits and advances, desired
maturity profile of the incremental assets and liabilities, etc. In addition to
monitoring the risk levels of the bank, the ALCO should review the
results of and progress in implementation of the decisions made in the
previous meetings. The ALCO would also articulate the current interest
rate view of the bank and base its decisions for future business strategy
on this view. In respect of the funding policy, for instance, its
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responsibility would be to decide on source and mix of liabilities or sale

of assets. Towards this end, it will have to develop a view on future
direction of interest rate movements and decide on a funding mix
between fixed Vs floating rate funds, wholesale Vs retail deposits, money
market Vs capital market funding, domestic Vs foreign currency funding,
etc. Individual banks will have to decide the frequency for holding their
ALCO meetings.
Composition of ALCO
The size (number of members) of ALCO would depend on the size of
each institution, business mix and organizational complexity. To ensure
commitment of the Top Management, the CEO/CMD or ED should head
the Committee. The Chiefs of Investment, Credit, Funds Management /
Treasury (Forex and domestic), International Banking and Economic
Research can be members of the Committee. In addition the Head of the
Information Technology Division should also be an invitee for building
up of MIS and related computerization. Some banks may even have sub-
committees.
Committee of Directors
Banks should also constitute a professional Managerial and Supervisory
Committee consisting of three to four directors which will oversee the
implementation of the system and review its functioning periodically.
2c. ALM process:

• Risk parameters
• Risk identification
• Risk measurement
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• Risk management
• Risk policies and tolerance levels.
3. The scope of ALM function can be described as follows:
• Liquidity risk management

• Management of market risks (including Interest Rate Risk)
• Funding and capital planning
• Profit planning and growth projection
• Trading risk management
Objective:
The primary objective of an Asset Liability Management system is
liquidity risk management and interest rate risk management.
During last couple of years, liquidity risk management did not pose a
challenge due to surplus liquidity in the banking system. The surplus
liquidity parked by banks with Reserve Bank of India touched Rs 554.75
billion in March 2004. The deposit growth has been phenomenal whereas
the credit off-take was negligible. However, since beginning of fiscal year
2008-09, the liquidity situation has changed.
Current Scenario
• Bank credit grew by 30.2 per cent as on January 5, 2009 as against
29.7 per cent a year ago. Nonfood credit grew by 31.2 per cent, at
the same rate as the previous year.
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• Credit growth has been largely broad-based. About 34 per cent of

the incremental non-food credit was absorbed by industry, 12 per
cent by agriculture, 29 per cent by personal loans and 25 percent by
'other loans'.
• Growth in aggregate deposits accelerated to 21.1 per cent as on
January 5, 2009, from 16.2 per cent in the previous year. Demand
deposits grew by 19.2 per cent Vis-a-Vis 28.7 per cent a year ago.
However, accretion to time deposits was significantly higher at
22.9 per cent from 15.0 percent in the previous year.
• High growth in time deposits, apart from the acceleration in
economic activity, can be attributed to higher deposit rates and tax
benefits under Section 80C for deposits with a maturity of 5 years
and above.
Therefore, liquidity risk management has become increasingly a

challenging task in Indian banks. Liquidity risk is often related to bank’s
inability to pay to its depositors. However, a bank’s inability to pay to its
depositors is the ultimate manifestation of liquidity risk. Liquidity risk at
initial stages may lead to distress pricing of assets and liabilities. A bank
with high degree of liquidity risk may be forced to borrow funds from
inter bank market at exorbitant rates or has to increase its deposit rates.
As the bank may not be able to transfer these increased costs to
borrowers, ultimately its net interest income shall be affected. Further, as
bank’s cost of funds goes up, increasingly it looks for risky avenues to
increase its earnings. The process may lead to wrong selection of
borrowers as well as venturing into risky areas (such as equity financing,
giving un-secured loans etc) increasing overall risk profile of the bank.
Therefore, liquidity risk has strong correlation with other risks such as
interest rate risk and credit risk.
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4. LIQUIDITY RISK MANAGEMENT

Liquidity risk is measured through either
• Stock approach or
• Flow approach.
Stock approach
Under stock approach certain standard ratios are computed. Some of the
ratios widely used in banks are
• Liquid assets to short-term liabilities,
• Core assets to core liabilities,
• Inter bank borrowings to total assets,
• Overnight borrowings to total assets etc.
However, management of liquidity through ratios suffers from some

drawbacks, as it does not factor market liquidity aspect of assets and
liabilities. For example, presence of some short term investments may
show the improved liquidity risk of the bank whereas the investment
itself may be highly illiquid. Further, the ratio, though good indicator of
liquidity, may be valid good for a point of time only as balance sheet
profile constantly changes. Therefore, the flow approach, the alternative
model for measuring and managing liquidity has been accepted by most
of the banks.
Flow approach
Under Flow approach cash flows are segregated into different maturity
ladders and net funding requirement for a given time horizon is
estimated. The net funding requirement over a given time horizon gives a
fair idea of liquidity risk faced by an institution. Reserve Bank of India
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has prescribed some statutory returns for submission of data on liquidity

risk and interest rate risk by banks.
The Maturity Profile as given in Appendix I could be used for measuring
the future cash flows of banks in different time buckets. The time buckets
given the Statutorythe Statutory Reserve cycle of 14 days may be
distributed as under:
i) 1 to 14 days
ii) 15 to 28 days
iii) 29 days and upto 3 months
iv) Over 3 months and upto 6 months
v) Over 6 months and upto 12 months
vi) Over 1 year and upto 2 years
vii) Over 2 years and upto 5 years
viii Over 5 years
)
See proper formatting
There are limits for liquidity mismatches in the first two buckets
prescribed by RBI. The mismatches as percentage to outflows should not
exceed negative 20% in the time buckets of 1-14 days and 15 days to 28
days.
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The above hypothetical chart indicates liquidity risk profile of a bank.

The bank has created long-term assets through short-term liabilities as
evident from negative mismatches in the near term buckets and positive
mismatches in long term buckets of 3-5 years and above 5 years. In the
process, the bank has exposed its liquidity profile to a great degree of risk
in two ways; first its liquidity position will depend on the roll over of
short term maturing liabilities and second, depending on adverse money
market conditions as well as external liquidity, it may be forced to
rollover maturing liabilities at a higher cost. In case, the long-term assets
are in the form of investments, the bank will be forced to sale assets at
loss to meet its liquidity requirements.
Generally banks perform an in-depth analysis of their liquidity profile
analyzing:
1) The profile of liability holders,
2) The extent of purchased fund providers,
3) ABC analysis of depositors etc.
They also prepare scenario analysis with different degrees of rollovers
and different level of asset securitization, asset sale and other realizations
to evolve the contingency funding requirement. Ultimately a plan is
prepared to meet liquidity requirements in the event of crisis and cost
thereof to meet the crisis. The Board of directors and top management
periodically review result of the exercise. Importance of liquidity risk
management has also been highlighted by Basel Committee on Banking
Supervision in the document “Sound Practices of managing Liquidity in
Banking Organizations”. World-wide, banking regulators are mandating
banks to conduct stress test and scenario analysis of liquidity risk and
prepare contingency plans to meet liquidity requirements in unforeseen
circumstances.
The major challenges faced by Indian Banks in liquidity management are:
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1. Maturities of bank deposits are shrinking over last couple of years.

This is mainly due to narrowing of liquidity premium paid by banks for
long-term deposits. For example, interest rates on deposits (of over 1 year
maturity) were in the range of 5.25%-6.25% in March 2008 as compared
to 9%-11.50% in March 1999. Therefore, a depositor has no incentive to
place his money in a bank’s long term fixed deposit.
2. With decline in interest rates, a sizeable portion of customers migrated

to other savings avenues like post office deposits, mutual funds etc
depriving banks of long term resources.
3. On the other hand, due to Dis-intermediation in corporate funding and

recession in past years, banks have been aggressively offering asset
products with long-term maturities (e.g. home loans). Falling interest
rates and lack of credit growth in past years prompted banks to put major
portion of their deposits in long-term government securities which may
not remain liquid at all times. Further, government securities are subject
to price risk and a bank may not be able to generate adequate liquidity
without selling them at loss.
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5. INTEREST RATE RISK MANAGEMENT

Interest rate risk management in banking book is a major objective of any
ALM system. Typically, a bank positions its assets and liabilities into
trading book and banking book. Interest rate movements cause price
changes in trading book and earnings/economic value changes in banking
book. While trading book assets and liabilities are held to take advantage
of short term price movements, banking book assets and liabilities arise
out of relationship/regulatory requirements and provide accrual income to
a bank. The top management of banks lay down policies with regard to
volume, maximum maturity, holding period, duration, stop loss,
defeasance period, rating standards, etc. for classifying securities in the
trading book. The assets held in the trading book are marked to market on
a daily basis. The tools and techniques of risk management and the plan
horizon also vary between trading book and banking book. While risk in
the trading book are measured on a real time basis through VAR, PV01
etc, interest rate risk in banking book is measured on a longer horizon say
a quarter or a year.
A bank’s banking book is exposed to following types of risk:
o Mis-match risk
o Basis risk
o Embedded option risk
o Yield curve risk
o Price risk
5a. Gap or mismatch risk

A gap or mismatch risk arises from holding assets and liabilities and off-
balance sheet items with different principal amounts, maturity dates or re-
pricing dates, thereby creating exposure to unexpected changes in the
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level of market interest rates. An example of gap risk is exhibited in the

following table:
(Note: the difference of Rs 600 Cr between assets and liabilities, re-

present non-sensitive liabilities e.g. Capital, Reserves, Current deposits
etc).
As the bank has negative mismatch in the first year (i.e. its maturing
liabilities are more than assets), its net interest margin or earnings will
decline in a rising rate scenario. The reverse will happen in a falling
interest rate scenario. Following is the relationship between a bank’s net
interest income, gap and direction of interest rate movements:
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A bank may strategically position its gaps in anticipation of interest rate

movements to increase its Net Interest Income.
5b.Basis Risk
Basis risk arises due to changes in market rates on different financial
instruments by varying degree. The risk that the interest rate of
different assetsa different asset, liabilities and off-balance sheet items
may change in different magnitudes is termed as basis risk. The degree of
basis risk is fairly high in respect of banks that create composite assets
out of composite liabilities. For example, a bank may be funding floating
rate loans linked to its Benchmark Prime Lending Rate (BPLR) through
composite liabilities of various maturities. The rates on these liabilities
may change by different degrees whereas the bank may not be able to
change its BPLR by same degree. This may result NII of the bank to
shrink in a rising interest rate scenario.
5c.Embedded Option Risk

Embedded option means possibility of alteration of cash flows to the
disadvantage of a bank. Traditionally banks have offered products with
embedded options. The depositors enjoy freedom to close their deposits
at any time by paying penalty. Similarly, there are embedded options with
loan products such as cash credit, demand loans and term loans. Banks
are experiencing embedded option even in stable interest rate
environments due to stiff competition. Pre-payments in home loans are
regular phenomenon. However, in volatile interest rate scenario, the
degree of usage of embedded option goes up. Banks statistically estimate
the extent of embedded options to be exercised by customers and
incorporate them in liquidity and interest rate risk models. The pricing of
such risks into deposit and loan products has also to happen. Though
Reserve Bank of India has permitted banks to deny premature closures in
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case of large deposits, they are currently not doing so due to fear of losing
business.
5d.Yield Curve Risk

Currently yield curve risk is limited in Indian Banks as mostly the assets
and liabilities in Indian banking system are either at fixed rate or at
floating rate linked to internal benchmarks. For example, through most of
the term loans and cash credit loans in banking system are at floating rate
linked to internal PLR of banks, the degree to which they respond to
changes in external benchmark rates is a matter of debate. Further, the
relevance of benchmark PLR is itself questionable when banks are
lending at sub-PLR rates. The concept of yield curve risk may be
explained with the following example:
5e.Price Risk
Banks are required to mark to market their investment portfolio in held for trading and
available for sale category. In the financial markets, prices of instruments and yields
are inversely related. During last three years prior to March 2008, due to slow credit
pick up, a large number of banks had invested in government securities more than
regulatory requirements. As per Reserve Bank of India’s guidelines banks may
classify their investments into three categories viz. a) Held for Trading (HFT) b)
Available for Sale (AFS) and c) Held till Maturity (HTM). While securities in HFT
and AFS categories are required to be marked to marked, the securities in HTM are
not. As interest rates declined, banks made huge treasury gains in their investment
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portfolio. However, due to rise in yields many banks reported treasury losses in
December quarter 2004. The losses would have been higher, had RBI not permitted
banks to shift a portion of their securities to ‘Held to Maturity’ class. However,
notwithstanding this accounting treatment, the rising interest rates will result in
economic loss of bonds held in held till maturity category.
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6. Management of Interest Rate Risk in Banking Book-

Earnings Perspective and Economic Value Perspective.
6a. Earnings perspective

As discussed in previous paragraphs, changes in interest rates will affect
net interest income of a bank in short run and its economic value in long
run. The impacts on earnings are computed with a perspective of a plan
horizon, which may vary from bank to bank. A bank sets a plan horizon
for computation of earnings at risk and groups all assets and liabilities
into different time buckets upto the plan horizon. It assumes a rate shock
at the beginning of the plan horizon and applies to all assets and liabilities
re-pricing during the horizon. Depending on the position of gaps and
likely interest rate shock, the analysis will present net gain or loss on NII.
A bank, as a prudent policy may put limits on its earnings at risk (EAR).
The limit may be expressed as EAR as percentage to net-worth, rate
sensitive gaps as percentage to total assets etc. Further, some banks refine
this process by applying different degree of rate changes on assets and
liabilities accepting the basis risk prevalent in their asset and liability
products, their customer profile and practicality of enforcing re-pricing of
contracts. The limits on gap positions can actively be managed either
through on or off-balance sheet strategies. For example, a bank with net
negative gap upto 1-year plan horizon and anticipating rates to harden up,
will pay in Overnight Index Swap (OIS) to improve positive mismatches
in short term buckets.
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The following tables illustrate gap management strategies:
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As illustrated above, both the strategies result in reduction of Earnings at

Risk from Rs (-) 16 Cr to Rs (-) 11 cr. However, the bank may have to
begin with negative earnings on swaps initially (for example while
paying in Swap the fixed leg (pay) will be higher than the floating leg
(MIBOR)), which needs to be factored in analysis. Though gap analysis,
as described above, is a very simple tool to manage interest rate risk in
banking book with short-term perspective, it suffers from some serious
limitations which need to be kept in mind: -
• The gap is computed as the rupee difference between the values of
rate sensitive assets and liabilities in the gapping period regardless
of when the repricing occurs. Thus if all assets re-price at the
beginning of the maturity period and the liabilities at the end of the
period the institution will not be insulated from interest rate risk
even though the gap is maintained at zero.
• The gap management might be hampered by the objectives of the
customers. In rising interest rate scenarios gap management
recommends shifting out of fixed rate assets to floating rate assets.
The customers may however demand fixed rate assets.
Additionally such adjustments in assets/liabilities may have to be
accomplished at the cost of trading off lower interest rate risk for
greater credit and default risk.
• Alternatively, such assets may be swapped at floating rate through
OIS. However, there has to be a definite view on magnitude as well
as quantum of interest rate increase, as there will be opportunity
loss through negative carry at the beginning.
• Gap management does not take into account that re-pricing spreads
of assets and liabilities which may not be identical i.e. it is possible
that the rise in interest rates on liabilities is proportionately higher
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than rise in interest rate on assets leading to a decline in spreads

despite an increase in the general level of rates.
• Gap management concentrates solely on flow of funds and
variability of revenues and does not focus on the effect of interest
rate on the market value of assets and liabilities.
6b.Economic value perspective

One of the objectives of an ALM system is to preserve and enhance long-
term economic value of a bank or its market value of equity.
Market value of equity (MVE) refers to net position of net-worth after
marking to market assets and liabilities. Similar to individual securities,
duration analysis can be used to assess the impact of interest changes on
the market value of the assets and liabilities of a bank. The Duration Gap
indicates the effect of interest rate changes on the net worth of the
institution. This serves as a strategic planning tool for evaluation and
controlling the interest rate risk of the institution. Duration gap analysis
can be used to immunize the relevant target account (assets, liabilities or
groups of assets and liabilities) against unexpected changes in interest
rates by setting the duration gap of the target account to zero. In a
positive duration gap this can be accomplished by lengthening the
duration of liabilities or shortening the duration of assets. However since
duration drift can occur with passage of time without any changes in
interest rate, the institution will have to regularly restructure the balance
sheet. Similarly, when
interest rates are expected to rise, the composition of balance sheet should
be restructured to obtain a negative duration gap.
Thus the market value of the institution will increase due to a greater
reduction in the value of liabilities than assets. A higher duration gap will
result in greater degree of changes in market value of equity. A banking
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institution may create a duration gap to improve market value of equity

depending on its interest rate view.
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7. Value at risk (VAR)

Risk in the trading book are measured on a real time basis
through VAR
Meaning
Throughout the centuries since man became a commercial animal,
investors and speculators have shared a common intuition that there is a
balance between fear and greed – between the risks of investments and
their potential rewards. The silk merchants of ancient China, the crowd
that gathered to trade shares under the buttonwood tree near what would
later become the NewYork Stock Exchange, and the denizens of modern
high-tech trading rooms have all shared a common concern: how to
quantify the risk of loss.
For a long time, the risk takers just guessed. After all to know with
certainty the magnitude of potential losses was to know the future! And
while methodologies for quantifying the risk of loss in various
circumstances – such as "duration" for fixed income securities – were
developed in recent decades, foreknowledge of market conditions was
required to answer with certainty.
The problem confronting investors and speculators was not unlike that
facing Modern scientistsModern scientists: predicting future events with
certainty is simply not possible. And it was only when financial market
participants adopted methodologies pioneered in the sciences that a
satisfactory gauge for market risk was developed. In adopting the
methods of the empirical sciences, which predict future events according
to the laws of probability and statistics, risk managers were obliged to
accept the highly probable, but nonetheless conditional answers they
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produce. Since the question "how much can I lose?" cannot be answered
with absolute certainty, market practitioners learnt to be satisfied with
answers to questions of a significantly different form: "With a degree of
confidence chosen by me, what is the largest loss I am likely to suffer?"
And it is questions of this form that is addressed when we compute the
value-at-risk of a position, or its VAR.
Meaning & how it is useful
First, VAR is an amount of money – which is what we mean when we
ask how much we can lose. Second VAR is an estimate. It is based upon
probabilities, so we cannot rely upon it with certainty, but rather with a
degree of confidence we select.
VAR is defined as the expected maximum loss (expressed in currency

units) due to unfavorable movement of the underlying market factors that
an asset or a portfolio of assets will suffer over a target horizon (T) within
a given degree of certainty / confidence level (a ) selected by the decision
maker.
The VAR concept embodies three factors. The first is given time horizon.
A risk manager might be concerned about possible losses over one day,
one week, one month, etc. Second, VAR is associated with a probability.
The stated VAR represents the maximum possible loss over a given
period of time with a given probability. Third, there is the actual rupee
amount itself. Consider for example a dealer with an Rs 20 million
position. He might find that his VAR for a one-day period, with a one
percent probability is Rs 500,000. This means that the dealer can expect
to lose at least Rs 500,000 in any given day about one percent of the time,
or in other words, 2.5 times in a year (assuming 250 trading days). Of
course the user can specify any probability or holding period and there
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are no hard or fast rules to help one decide on the appropriate probability
and holding period.
How does one choose appropriate holding period and

confidence level?
The choice of the holding period depends on the liquidity of the market
under consideration. As far as probability is concerned, the choice is
purely subjective. Bankers Trust uses a 99 percent level; Chemical and
Chase, a 97.5 percent level; Citibank a 95.4% level; Bank America and
J.P.Morgan a 95 percent level. For internal models of capital allocation,
the Basle Committee recommends a multiple of three (with an additional
factor depending on the failure rate of the VAR limit in the past) of the
VAR, calculated using 10 day holding period and 99 percent level of
confidence.
The concept of VAR is a very appealing one. It can be developed for any
kind of portfolio and can be aggregated across portfolios of different
kinds of instruments. For example, a bank might have a portfolio of
interest rate swaps, a portfolio of currencies, positions in some
commodities and a portfolio of common stocks, as well as its regular loan
and bond portfolios. The VAR for each separate portfolio can be
calculated and aggregated across all portfolios. This does not imply that
estimating VAR for a portfolio is a simple process; the correlations across
asset classes must be accounted for. VAR does, however provide a
consistent measure across portfolios. Thus with appropriate
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considerations for all correlations, VAR can provide the bank with an
overall measure of exposure.
An attractive feature of VAR is that it is stated in terms of rupees. Senior

management and anyone without much technical knowledge of financial
products can still easily understand the concept.
How is VAR computed?

Now let us examine how VAR is computed. First we begin with a simple
example that takes the required inputs as given. Later we shall look at
how this information is obtained. Suppose that a firm has compiled the
following information about the change in the value of a portfolio over a
one-week period.
Change in Value Probability
<= Rs 1,000,000 0.01
-Rs 500,000 to – Rs 999,999 0.04
-Rs 250,000 to – Rs 499,999 0.15
Rs 0 to – Rs -249,999 0.30
Rs 1 to Rs 249,999 0.30
Rs 250,000 to Rs 499,999 0.15
Rs 500,000 to Rs 999,999 0.04
>=Rs 1,000,000 0.01
From this information we can say that VAR at 1% probability is –Rs

1,000,000. This means that the firm would expect to lose atleast Rs
1,000,000 one percent of the time. A common misconception about VAR
is that it is the maximum expected loss. It should be apparent that this is
not what VAR is. We do not say that the most the firm could lose 1
28
percent of the time is Rs 1 million. Obviously the firm could lose more
than Rs 1 million.
From the above table we can also easily define VAR at 5 percent, which
is –Rs 500,000. There is a 4 percent chance of a loss between Rs 500,000
and Rs 999,999 plus a one percent chance of a loss of atleast Rs 1
million. Thus the firm can expect to lose atleast Rs 500,000 five percent
of the time.
The probability distribution given above is a simple discrete distribution.

Sometimes a firm will prefer to use a continuous distribution, the Normal
Distribution being a common one. When that is the case, then the user
must know the expected change in value, E (D V), and the standard
deviation, s (D V). From there, one can compute VAR as
VAR (1%) = E (D V) – 2.33 s (D V)
VAR (5%) = E (D V) – 1.65 s (D V)
These numbers 2.33 and 1.65, represent the number of standard

deviations to the left of the expected value that leave 1 percent and 5
percent, respectively in the tail of the distribution.
For example, suppose a firm estimates that a change in its portfolio value
is Rs 1,000,000 with a standard deviation of Rs 1.5 million. Thus VAR
(1%) = Rs 1,000,000 – 2.33 (Rs 1,500,000) = Rs –2,495,000 and VAR
(5%)= Rs 1,000,000 – 1.65(Rs 1,500,000)= -Rs 1,475,000). Thus the firm
could expect to lose atleast Rs 2,495,000 one percent of the time and lose
atleast Rs 1,475,000 five percent of the time.
29
A discrete distribution is, in many cases, merely a simplification of a

continuous distribution. In finance virtually all risks are associated with
continuous distributions. The more critical problem however, is not
whether to use a discrete or continuous distribution but how to obtain the
inputs.
How does one obtain the inputs to be entered into a generic

VAR model?
Determination of Value at Risk necessitates modeling the movement in
market factors. The modeling can be done either by use of simulation
methods or analytic methods. Simulation methods are heavily dependent
on either the values assumed by the market factor in the past or what we
expect it to assume in future.
The Historical Simulation method requires that the user obtain historical
information on the movement of market factors (share prices, interest rate
yield curve, exchange rates, commodity prices etc) which determine the
performance of the financial instruments that are in the current portfolio.
This means a time series of the prices or returns on these assets. From the
historical data, the user can calculate the observed changes in the market
factors over the time horizon to be used in the VAR calculation.
Obviously this method relies heavily on the assumption that the portfolio
distribution from the past continues to hold for the future.
Alternatively the user might do a Monte Carlo simulation. Using the

parameters estimated from the past data, the user can then generate
random numbers to represent market prices, interest rates etc. and for
each simulation run, the value of the portfolio is determined. The
30
simulation enables one to construct a frequency distribution from which

VAR can be picked off from the left tail. These descriptions provide a
general idea behind the historical method but the implementation is not as
quite straightforward as it might seem. To produce a portfolio Variance it
is necessary to estimate correlations among the different classes of
instruments. For a Monte Carlo simulation, one must generate random
numbers representing prices, interest rates, and exchange rates according
to relative frequency with which these numbers would appear in practice.
Analytic methods, on the other hand, solve for the VAR limit, i.e. the (1-
A ) the percentile, based on distributional assumptions about the
movement of market factors and the estimated parameters. For example,
under the assumption of a normal distribution with zero mean and
standard deviation s , the 95% VAR limit (the absolute value of the fifth
percentile of the distribution) is given by 1.65*s.
What are the key steps for computation of Value at Risk by

analytic method?
In general, the analytic method for calculation of Value at Risk follows
the following steps:
• Identifying exposures and cash flows
Cash flow is the building block for describing any position. A cash flow
is defined by an amount of currency, a payment date and the credit
standing of the payer Onceonce determined these cash flows are marked
to market. Marking to market a position's cash flows means determining
the present value of the cash flows given current market rates and prices.
This procedure requires current market rates, including a zero coupon
yield curve to value fixed income securities.
31
• Mapping cashflowscash flows on certain vertices
Financial instruments , in general, can generate numerous cashflows ,

each one occurring at a unique time. This gives rise to an unwieldy
number of combinations of cash flows dates when many instruments are
considered. As a result, we are faced with the impractical task of having
to compute an intractable number of volatilities and correlations for the
VAR calculation. To more easily estimate the risks associated with
instruments' cashflows, we need to simplify the time structure of these
cashflows.
One of the methods of simplifying time structure involves cash flow

mapping, i.e., redistributing (mapping) the observed cash flows onto
certain vertices.
• Computing Value at Risk
Two analytical approaches can be used to measure Value-at-Risk :

Simple VAR for linear instruments, and Delta-Gamma VAR for
nonlinear instruments, where the terms "linear" and "nonlinear" describe
the relationship of a position's underlying returns to the position's relative
change in value.
In the simple VAR approach, we assume that returns on securities follow

a conditionally MultiVariate normal distribution and that relative change
in a position's value is a linear function of the underlying return. Defining
VAR as the 5th percentile of the distribution of a portfolio's relative
changes, we compute VAR as 1.65 times the portfolio's standard
32
deviation. Where the multiple 1.65 is derived from the normal

distribution. This standard deviation depends on the volatilities and
correlations of the underlying returns and on the present values of the
cash flows.
In the Delta-Gamma approach, we continue to assume that returns on

securities are normally distributed, but allow for a nonlinear relationship
between the position's value and the underlying returns. Specifically we
allow for a second-order or gamma effect , which implies that the
distribution of the portfolio's relative change is no longer normal.
Is VAR a panacea to prevent all risks ?risks?
VAR is one of the essential tools of the risk manager but it is not the
whole story. Its purpose is to give an estimate of losses over a short
period under "normal" market conditions. It is not going to tell you what
might happen during a market crash for that stress testing and scenario
analysis are necessary.
Also as the Barings debacle showed, any risk measurement system is

only as good as the numbers that go into it. A rogue trader entering false
positions will undermine the usefulness of VAR reports. So the method,
while extremely powerful for day to day risk management , is no
substitute for wider risk management process of analysing crash scenarios
and keeping tabs on operational and legal risks.
33
8. Implementation of the Guidelines - Instructions from RBI

to Banks
In this context RBI gave the following instructions with reference to

implementation of the guidelines.
1. Banks should give adequate attention to putting in place an

effective ALM System. Banks should set up an internal Asset-
Liability Committee (ALCO), headed by the CEO/CMD or the ED.
The Management Committee or any specific Committee of the
Board should oversee the implementation of the system and review
its functioning periodically.
2. Keeping in view the level of computerization and the current MIS
in banks, adoption of a uniform ALM System for all banks may not
be feasible. The final guidelines have been formulated to serve as a
benchmark for those banks which lack a formal ALM System.
Banks which have already adopted more sophisticated systems
may continue their existing systems but they should ensure to fine-
tune their current information and reporting system so as to be in
line with the ALM System suggested in the Guidelines. Other
banks should examine their existing MIS and arrange to have an
information system to meet the prescriptions of the new ALM
System. To begin with, banks should ensure coverage of at least
60% of their liabilities and assets. As for the remaining 40% of
their assets and liabilities, banks may include the position based on
their estimates. It is necessary that banks set targets in the interim,
for covering 100 per cent of their business by 1ST April , 2000. The
MIS would need to ensure that such minimum information/data
consistent in quality and coverage is captured and once the ALM
34
System stabilizes and banks gain experience, they must be in a

position to switch over to more sophisticated techniques like
Duration Gap Analysis, Simulation and Value at Risk for interest
rate risk management.
3. In order to capture the maturity structure of the cash inflows and
outflows, the Statement of Structural Liquidity Annexure-I should

be prepared, to start with, as on the last reporting Friday of
March/June/ September/December and put up to ALCO/Top
Management within a month from the close of the last reporting
Friday. It is the intention to make the reporting system on a
fortnightly basis by 1ST April ,April, 2000. The Statement of
Structural Liquidity should be placed before the bank's Board in
the next meeting. It would also be necessary to take into account
the rupee inflows and outflows on account of previously contracted
forex transactions (swaps, forwards, etc). Tolerance levels for
various maturities may be fixed by the bank's Top Management
depending on the bank's asset - liability profile, extent of stable
deposit base, the nature of cash flows, etc. In respect of
mismatches in cash flows for the 1-14 days bucket and 15-28 days
bucket, it should be the endeavour of the bank's management to
keep the cash flow mismatches at the minimum levels. To start
with, the mismatches (negative gap) during 1-14 days and 15-28
days in normal course may not exceed 20% each of the cash
outflows during these time buckets. If a bank in view of its
structural mismatches needs higher limit, it could operate with
higher limit with the approval of its Board/Management
Committee, giving specific reasons on the need for such higher
limit. The objective of RBI is to enforce the tolerance levels strictly
by 1ST April , 2000.
35
4. In order to enable the banks to monitor their liquidity on a dynamic
basis over a time horizon spanning from 1-90 days, an indicative

format Annexure III is enclosed. The statement of Short-term
Dynamic Liquidity should be prepared as on each reporting Friday
and put up to the ALCO/Top Management within 2/3 days from
the close of the reporting Friday.
5. We advise that in the Statement of Interest Rate Sensitivity
Annexure - II only rupee assets, liabilities and off-balance sheet

positions should be reported. The statement should be prepared as
on the last reporting Friday of March/June/September/December
and submitted to the ALCO / Top Management within a month
from the last reporting Friday. It should also be placed before the
bank's Board in the next meeting. The banks are expected to move
over to monthly reporting system by 1st April ,April, 2000. The
information collected in the statement would provide useful
feedback on the interest rate risk faced by the bank and the Top
Management/Board would have to formulate corrective measures
and devise suitable strategies wherever needed.
6. The guidelines for ALM cover the banks' operations in domestic
currency. In regard to foreign currency risk, banks should follow

the instructions contained in Circular AD (MA Series) No.52 dated
27th December ,December, 1997 issued by the Exchange Control
Department."
36
9. CONCLUSION
Interest rate risk and liquidity risks are significant risks in a bank’s
balance sheet, which should be regularly monitored and managed. These
two aspects should be a key input in business planning process of a bank.
Banks should make sure that increased balance sheet size should not
result in excessive asset liability mismatch resulting in volatility in
earnings. There should be proper limit structures, which should be
monitored by Asset Liability Management Committee (ALCO) on) on a
regular basis. The effectiveness of ALM system should be improved
with a good Fund Transfer Pricing system.
10. Bibliography
www.google.com
Indian Institute of Banking and Finance
www.rbi.org
www.economicstimes.com
37
11. Appendix & Annexures

APPENDIX - I
Maturity Profile - Liquidity
Heads of Accounts Classification into time buckets

A. Outflows
1. Capital, Reserves and Surplus Over 5 years bucket.
2. Demand Deposits (Current and SavingsDemand Deposits may be classified into

Bank Deposits) volatile and core portions. 25% of
deposits are generally withdrawable on
demand. This portion may be treated as
volatile. While volatile portion can be
placed in the first time bucket i.e., 1-14
days, the core portion may be placed in 1
- 2 years bucket.
3. Term Deposits Respective maturity buckets.
4. Certificates of Deposit, BorrowingsRespective maturity buckets.

and
Bonds (including Sub-Ordinate Debt)
5. Other Liabilities and Provisions

(i) Bills Payable (i) 1-14 days bucket.
(ii) Inter-office Adjustment (ii) As per trend analysis. Items not
representing cash payables, may be
placed
in over 5 years bucket.
(iii) Provisions for NPAs (iii)
a) Sub-standard a) 2-5 years bucket.
b) Doubtful and Loss b) Over 5 years bucket.
(iv) Provisions for depreciation in(iv) Over 5 years bucket.
investments
(v) Provisions for NPAs in investments(v)
a) Sub-standard a) 2-5 years bucket.
b) Doubtful and Loss b) Over 5 years bucket.
38
(vi) Provisions for other purposes (vi) Respective buckets depending on the
purpose.
(vii Other Liabilities (vii Respective maturity buckets. Items
) ) not
representing cash payables (i.e.
income received in advances etc.)
may be placed in
over 5 years bucket.
B. Inflows
1. Cash 1-14 days bucket
2. Balances with RBI While the excess balance over the

required CRR/SLR may be shown under
1-14 days bucket, the Statutory Balances
may be distributed amongst various time
buckets corresponding to the maturity
profile of DTL with a time-lag of 14
days.
3. Balances with other Banks

(i) Current Account (i) Non-withdrawable portion on
account of
stipulations of minimum balances
may be
shown under 1-2 years bucket and
the
remaining balances may be shown
under
1-14 days bucket.
39
(ii) Money at Call and Short Notice,(ii) Respective maturity buckets.

Term Deposits and other
placements
4. Investments
(i) Approved securities (i) Respective maturity buckets
excluding the
amount required to be reinvested to
maintain SLR corresponding to the
DTL
profile in various time buckets.
(ii) Corporate debentures and bonds,(ii) Respective maturity buckets.
PSU bonds, CDs and CPs, Investments
Redeemable preference Shares, classified as NPAs should be shown
Units of Mutual Funds under
(close ended), etc. 2-5 years bucket (sub-standard) or
over 5
years bucket (doubtful and loss).
(iii)Shares / Units of Mutual Funds(iii)Over 5 years bucket.
(open ended)
(iv)Investments in Subsidiaries/Joint(iv)Over 5 years bucket.
Ventures
5. Advances (Performing)
(i) Bills Purchased and Discounted(i) Respective maturity buckets.
(including bills under DUPN)
(ii) Cash Credit/Overdraft (including(ii) Banks should undertake a study of
TOD) and Demand Loan behavioural and seasonal pattern of
component of Working Capital. availments based on outstandings
and the core and volatile portion
should be identified. While the
volatile portion could be shown in
the respective maturity buckets, the
core portion may be shown under 1-
2 years bucket.
(iii)Term Loans (iii)Interim cash flows may be shown
under respective maturity buckets.
40
6. NPAs
(i) Sub-standard (i) 2-5 years bucket.
(ii) Doubtful and Loss (ii) Over 5 years bucket.
7. Fixed Assets Over 5 years bucket
8. Other Assets
(i) Inter-office Adjustment (i) As per trend analysis. Intangible
items or items not representing cash
receivables may be shown in over 5
years bucket.
(ii) Others (ii) Respective maturity buckets.
Intangible assets and assets not
representing cash receivables may be
shown in over 5 years bucket.
C. Contingent Liabilities / Lines of Credit

committed / available and other Inflows /
Outflows
1. (i) Lines of Credit committed to(i) 1-14 days bucket.

Institutions (outflow)
(ii) Unavailed portion of Cash Credit /(ii) Banks should undertake a study of the
Overdraft / Demand loan behavioural and seasonal pattern of
component potential availments from the
of Working Capital limits (outflow) accounts and the amounts so arrived
at may be shown under relevant
maturity buckets upto 12 months.
41
2. Letters of Credit / Guarantees (outflow)Historical trend analysis ought to be

conducted on the developments and the
amounts so arrived at in respect of
outstanding Letters of Credit / Guarantees
(net of margins) should be distributed
amongst various time buckets.
3. Repos / Bills Rediscounted (DUPN) /Respective maturity buckets.

Swaps INR / USD, maturing forex
forward contracts etc. (outflow /
inflow)
4. Interest payable / receivableRespective maturity buckets.

(outflow / inflow)
Note :
(i) Liability on account of any other contingency may be shown under respective
maturity buckets.
(ii) All overdue liabilities may be placed in the 1-14 days bucket.
(iii) Interest and installments from advances and investments, which are overdue
for less than one month may be placed in the 3-6 months, bucket. Further,
interest and installments due (before classification as NPAs) may be placed in
the 6-12 months bucket without the grace period of one month if the earlier
receivables remain uncollected.
D. Financing of Gap:
In case the negative gap exceeds the prudential limit of 20% of outflows, the bank
may show by way of a foot note as to how it proposes to finance the gap to bring the
mismatch within the prescribed limits. The gap can be financed from market
borrowings (call / term), Bills Rediscounting, Refinance from RBI / others, Repos and
42
deployment of foreign currency resources after conversion into rupees ( unswapped

foreign currency funds ) etc.
APPENDIX - II
Interest Rate Sensitivity
Heads of Accounts Rate sensitivity and time bucket
Liabilities
1. Capital, Reserves and Surplus Non-sensitive.
2. Current Deposits Non-sensitive.
Sensitive to the extent of interest paying

(core) portion. This may be included in
3. Savings Bank Deposits the 3-6 months bucket. The non-interest
paying portion may be shown in non-
sensitive bucket.
43
Sensitive and reprices on maturity. The

amounts should be distributed to different
buckets on the basis of remaining
Term Deposits and Certificates of
4. maturity. However, in case of floating
Deposit
term deposits, the amounts may be shown
under the time bucket when deposits
contractually become due for repricing.

amounts should be distributed to different
5. Borrowings – Fixed
buckets on the basis of remaining
maturity.
Sensitive and reprices when interest rate

is reset. The amounts should be
6. Borrowings - Floating
distributed to the appropriate bucket
which refers to the repricing date.

7. Borrowings - Zero Coupon amounts should be distributed to the
respective maturity buckets.
8. Borrowings from RBI Upto 1 month bucket.
(a) Fixed rate : As per respective

9. Refinances from other agencies.
maturity.
(b) Floating rate : Reprices when interest
rate is reset.
10.Other Liabilities and Provisions

(i) Bills Payable (i) Non-sensitive.
(ii)Inter-office Adjustment (ii) Non-sensitive.
(iii
Provisions (iii)Non-sensitive.
)
(iv
Others (iv) Non-sensitive.
)
Reprices only on maturity and should be

Repos/Bills Re-discounted (DUPN),
11. distributed to the respective maturity
Swaps (Buy / Sell) etc.
buckets.
44
Assets
1. Cash Non - sensitive.
Interest earning portion may be shown in

2. Balances with RBI 3 - 6 months bucket. The balance amount
is non-sensitive.
3. Balances with other Banks

(i) Current Account (i) Non-sensitive.
Money at Call and Short Notice, Sensitive on maturity. The amounts
(ii) Term Deposits and other(ii) should be distributed to the respective
placements. maturity buckets.
4. Investments (Performing)
(i) Fixed Rate / Zero Coupon (i) Sensitive on maturity.
(ii)Floating Rate (ii) Sensitive at the next repricing date
5. Shares / Units of Mutual Funds Non-sensitive.
6. Advances (Performing)
Bills Purchased and Discounted
(i) (i) Sensitive on maturity
(including bills under DUPN)
Sensitive only when PLR/risk
premium is changed. Of late, frequent
Cash Credits / Overdrafts changes in PLR have been noticed.
(including Thus, each bank should foresee the
(ii) (ii)
TODs) / Loans repayable on direction of interest rate movements
demand and Term Loans and capture the amounts in the
respective maturity buckets by which
time PLR would be revised.
7. NPAs (Advances and Investments) *

(i) Sub-Standard (i) 2-5 years bucket.
(ii)Doubtful and Loss (ii) Over 5 years bucket.
8. Fixed Assets Non-sensitive.
9. Other Assets.
(i) Inter-office Adjustment (i) Non-sensitive.
(ii)Others (ii) Non-sensitive.
45
Reverse Repos, Swaps (Sell/Buy) and

10. Sensitive on maturity.
Bills Rediscounted (DUPN)
11.Other products (Interest Rate)

Sensitive and should be distributed
(i) Swaps (i) under different buckets with
reference to maturity.
Should be suitably classified as and
(ii)Other Derivatives (ii)
when introduced.
* Amounts to be shown net of provisions.
ANNEXURE –
I
NAME OF THE
BANK
Statement of Structural Liquidity

as on
(Amounts in Cr. of Rupees)

RESIDUAL MATURITY
1-14 15-28 29 3-6 6-12 1-2 2-5 Over Total
days 5
Days days to 3 Mont month years years years
hs s
OUTFLOWS month
s
1. Capital
2. Reserves & Surplus
3. Deposits XXX XXX XXX XXX XXX XXX XXX XXX XXX
(i) Current Deposits
(ii) Savings Bank
Deposits
(iii) Term Deposits
(iv) Certificates of
Deposit
4. Borrowings XXX XXX XXX XXX XXX XXX XXX XXX XXX
(i) Call and Short Notice
(ii) Inter-Bank (Term)
46
(iii) Refinances
(iv) Others (specify)
5. Other Liabilities &XXX XXX XXX XXX XXX XXX XXX XXX XXX
Provisions
(i) Bills Payable
(ii) Inter-office
Adjustment
(iii) Provisions
(iv) Others
6. Lines of CreditXXX XXX XXX XXX XXX XXX XXX XXX XXX
committed to
(i) Institutions
(ii) Customers
7. Unavailed portion of
Cash
Credit / Overdraft /
Demand Loan
component of Working
Capital
8. Letters of Credit /
Guarantees
9. Repos
10. Bills Rediscounted
(DUPN)
11. Swaps (Buy/Sell) /
maturing
Forwards
12. Interest payable
13. Others (specify)
A. TOTAL OUTFLOWS
INFLOWS
1. Cash
2. Balances with RBI
3. Balances with otherXXX XXX XXX XXX XXX XXX XXX XXX XXX
Banks
(i) Current Account
(ii) Money at Call and
Short
Notice, Term Deposits
and other
Placements
4. Investments (including
those
47
under Repos but

excluding Reverse
Repos)
5. Advances(Performing) XXX XXX XXX XXX XXX XXX XXX XXX XXX
(i) Bills Purchased and
Discounted
(including bills under
DUPN)
(ii) Cash Credits,
Overdrafts and
Loans repayable on
demand
(iii) Term Loans
6. NPAs (Advances and
Investments)
7. Fixed Assets
8. Other Assets XXX XXX XXX XXX XXX XXX XXX XXX XXX
(i) Inter-office
Adjustment
(ii) Others
9. Reverse Repos
10. Swaps (Sell / Buy)/
maturing
Forwards
11. Bills Rediscounted
(DUPN)
12. Interest receivable
13. Committed Lines of
Credit
14. Others (specify).
B. TOTAL INFLOWS
C. MISMATCH ( B-A )
D. CUMULATIVE
MISMATCH
E. C as % To A
48
ANNEXURE – III
Name of the
Bank
Statement of Short-term Dynamic

Liquidity as on
(Amounts in Crores of
Rupees)
A. Outflows
1 - 14 15-28 29-90
days
Days Days
1 Net increase in loans and advances

2 Net increase in investments:
i) Approved securities
ii) Money market instruments (other than
Treasury bills)
iii) Bonds/Debentures/shares
iv) Others
3 Inter-bank obligations
4 Off-balance sheet items (Repos, swaps, bills
discounted, etc.)
5 Others
TOTAL OUTFLOWS
B. Inflows
1 Net cash position
2 Net increase in deposits (less CRR obligations)
3 Interest on investments
4 Inter-bank claims
5 Refinance eligibility (Export credit)
6 Off-balance sheet items (Reverse repos, swaps,
bills discounted, etc.)
49
7 Others
TOTAL INFLOWS
C. Mismatch (B - A)
D. Cumulative mismatch
E. C as a % to total outflows
50

Executive Summary: Assets and Liability Management by Banks in India

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Assets and Liability Management by Banks in India

Asset-liability management refers to the overall control of the

INDEX (Put in the Table form)

1b. Why ALM?

banks' operations have become complex and large, requiring strategic

"Banks need to address these risks in a structured manner by

various types of risks and altering the asset-liability portfolio in a

2. The ALM process rests on three pillars:

2a. ALM Information Systems

2b. ALM Organization

responsibility would be to decide on source and mix of liabilities or sale

2c. ALM process:

3. The scope of ALM function can be described as follows:

• Liquidity risk management

• Credit growth has been largely broad-based. About 34 per cent of

Therefore, liquidity risk management has become increasingly a

4. LIQUIDITY RISK MANAGEMENT

However, management of liquidity through ratios suffers from some

has prescribed some statutory returns for submission of data on liquidity

The above hypothetical chart indicates liquidity risk profile of a bank.

1. Maturities of bank deposits are shrinking over last couple of years.

2. With decline in interest rates, a sizeable portion of customers migrated

3. On the other hand, due to Dis-intermediation in corporate funding and

5. INTEREST RATE RISK MANAGEMENT

o Embedded option risk

o Yield curve risk

5a. Gap or mismatch risk

level of market interest rates. An example of gap risk is exhibited in the

(Note: the difference of Rs 600 Cr between assets and liabilities, re-

A bank may strategically position its gaps in anticipation of interest rate

5c.Embedded Option Risk

5d.Yield Curve Risk

6. Management of Interest Rate Risk in Banking Book-

6a. Earnings perspective

The following tables illustrate gap management strategies:

As illustrated above, both the strategies result in reduction of Earnings at

than rise in interest rate on assets leading to a decline in spreads

6b.Economic value perspective

institution may create a duration gap to improve market value of equity

7. Value at risk (VAR)

VAR is defined as the expected maximum loss (expressed in currency

How does one choose appropriate holding period and

An attractive feature of VAR is that it is stated in terms of rupees. Senior

How is VAR computed?

From this information we can say that VAR at 1% probability is –Rs

The probability distribution given above is a simple discrete distribution.

These numbers 2.33 and 1.65, represent the number of standard

A discrete distribution is, in many cases, merely a simplification of a

How does one obtain the inputs to be entered into a generic

Alternatively the user might do a Monte Carlo simulation. Using the

simulation enables one to construct a frequency distribution from which

What are the key steps for computation of Value at Risk by

• Mapping cashflowscash flows on certain vertices

Financial instruments , in general, can generate numerous cashflows ,

One of the methods of simplifying time structure involves cash flow

• Computing Value at Risk

Two analytical approaches can be used to measure Value-at-Risk :

In the simple VAR approach, we assume that returns on securities follow

deviation. Where the multiple 1.65 is derived from the normal

In the Delta-Gamma approach, we continue to assume that returns on

Is VAR a panacea to prevent all risks ?risks?

Also as the Barings debacle showed, any risk measurement system is