Asset Liability Management (ALM)

The spread between yield on their assets and the cost of their liabilities represents their margin. This margin otherwise known as Net Interest Margin, together with various other income such as commissions, profit on exchange, remittance fees, non-fund business income, etc. after reckoning all costs including staff and over heads represents their overall profits

During the administered interest rate regime the Net interst margin were so high that the fluctuations in interest rates did not really bother the banks as the spread was quite high. Mis matches in assets and liabilities prior to 1970s tended not to be a significant problem. In most developed countries interest rates witnessed only a modest fluctuations. Losses due to assets-liabilities mis matches were negligible. Many banks managed with mis-matches, at times deliberately as yield curves were generally upward sloping. They could earn a spread by borrowing short and lending long.

Let us assume the case of a bank with a share capital of 20 crores, raises 1000 thousand crores @ by way of liabilities at 3% per annum and lends the same to their good clients for 5 years @4%. For convenience, let us also assume interest rates are annually compounded and interst accumulates upto the due date of the obligations. The transaction overall appears to be profitable the bank will be earning a spread of 100 basis points (1%). That is about 10 crores.

The risks in the above transaction are

1. Interest rate fluctuation.

2. Every year end, bank should find new finacing source (Good borrowing customers)

3. Terms of such renewal un known.

4. Market liquidity at the time of raising such funds then.

5. Deployment of annually repaid instalments(Sourcing good customers, acceptable terms, lead time for processing, interest rate etc)

6. Default.

Taking first three of the risks indicated. Let us suppose that at the end of the first year, of the 5 year term loan, the interest rate moves up by 3 for enabling bank to fund the outstanding under the loan to the extent of 800 crores by raising the liability at a cost of 5%. The loan,however will carry the contracted interest rate @4%. The one percent positive spread will become negative to the extent of 1%. Under the accrual accounting system, the transaction would still appear profitable, inspite of the moved up interest rate.

Asset(Loans)---------1000 crores into 1040---------1040 crores

Liability-----------1000 " into 1030----------1030 "

Rs.10 crores profit made up of interest spread.

It is only the market value accounting that recognizes the banks real predicament according to which the position would appear as below.

Asset ----- 1000into(1040)

-------------

1000 into(1050)

It can be seen that from the market value perception, the bank had lost nearly 5 crores and the system clearly brings out the position whereas the accrual system hides the reality, ofcourse not for ever. At the end of the loan period, the real position will emerge and the bank can remain under false comfort during the period of the loan. The spread loss however is mitigated by the redeployment of 200 crores repaid to be lent at 6% or more. This will be for the second year.

To illustrate the misery of unpreparedness of the interest rate risk management the classic cases are those of the mutual funds in 1980s. They raised long term liabilities at fixed rates and deployed them with a spread that looked attractive when the deployments took place. In the fallen interest regime, the investors were still to get the almost guaranteed return whereas the yield on the funds deployed varied. Yin the fallen interest rate scenario they could not realize the guaranteed the interest.

Several mutual funds deployed the funds raised under fluctuating interest bearing investments. Mis matches in liquidity funded on short term basis, with interest hovering around quite high. The short term rates were in good Teens and the funding cost virtually caused collapse of several mutual funds.

Classic example is the case of EQUITABLE, a mutual life insurance company in U.S. This company had sold number of long term GIC contracts, guaranteeing yields @16%. In 1980s the short term interest yield curve got inverted and the short term rates were hovering well above 10% and then on around Teens. Equitable thought that they could raise huge resources and deploy in short term to take advantage of the spiking Short term rates.

Each GIC contract was for a minimum of Us#100 million for 10 years@16%. As ill luck would have it the short term rates nose dived and came down drastically. Repayments coming from the short term loans could not be redeployed at any rate near 16% guaranteed. The result was colossal loss booking and ultimately default in meeting the obligations. Equitable had to be de-mutualised and sold to Axa group

In India too such misery occurred and perhaps part of the problems faced by Unit trust of India could be on account of costly resources, guaranteed yield to investors, poor decisions on deployment, crash of stock market prices, mis matches and fluctuated interest rates both on short term and long term. Public and investors remained in darkness partly due to accrual system of accounting which did not bring to light the real problem.

The traditional approach to accounting do not bring out the hidden dangers as under the system neither the value of the fall nor the value of the liability rises. The impact of on the assets and liabilities due to interest rate fluctuations, delay in payments, liquidity in the market, redeployment scope and acceptable terms etc could, individually. collectively or by combination be very severe on the institution which may even collapse. This is so because such staggering losses have to fall on the Capital which size is disproportionate to the size of the liabilities or assets.

Basle recommendations focuses itsattention mainly on the size of capital in banks. Already banks are struggling to raise the minimum capital needs and there is going to be additional capital to be brought in to cover Market risks and Operational risks. Under this circumstance it will be unwise to lose the existing capital by risk which are anticipated particularly the Asset-Liability risk

Asset-Liability risk is therefore a leveraged risk. The narrowing of the difference between liabilities and assets which may fail to move in tandem can cut into the Capital which is disproportionately low compared to the size of the balance sheet total. A small percentage of change in assets and liabilities can culminate into larger percentage of depletion of capital funds

Asset-liability risk is leveraged by the fact that the values of assets and liabilities each tend to be greater than the value of capital. In this example, modest fluctuations in values of assets and liabilities result in a 50% reduction in capital.