CAIIB-RISK MANAGEMENT- ASSET LIABILITY MANAGEMENT – MODULE A

1. CAIIB-RISK MANAGEMENT- ASSET LIABILITY MANAGEMENT – MODULE A G.R.RAO, Faculty, IIBF

2. BANKING BUSINESS ON 26.09.2008 figures in crores DEMAND DEPOSITS 4,96,673 TERM DEPOSITS 29,45,465 34,42,138 LOANS, CC,OD 24,36,890 BILL FINANCE 1,05,577 25,42,467 CASH : DEPOSIT RATIO = 9.91 CREDT: DEPOSIT RATIO =73.86

3. BANKING BUSINESS Contd... C R R : 9 S L R : 25 TOTAL 34 HOW BANKS MANAGE CREDIT & CASH TOTALLING 83.77 % OF DEPOSITS BORROWING TO DEPOSITS: 11.74 %

4. PRESENT DAY PRORITIES • NET PROFIT WHICH IS OPERATING PROFIT - PROV. & APPROPRIATIONS • OPERATING PROFIT (OP) =INT. INC. + OTH. INC. NET.INT. INC.(NII) ALSO CALLED SPREAD = INT. (EARNED – SPENT) O.P. = (INT. EARNED – INT.SPENT) - OTHER (EXPNS. – INC.)

5. NII AND NIM • BANKS WILL BE INTERESTED IN NIM AND WOULD LIKE TO SEE IT GROW • NIM MANAGEMENT IS MAINLY ASSET AND LIABILITY MANAGEMENT • IT MANAGES ASSETS AND LIABILITIES TO IMPROVE NIM UNDER A GIVEN RISK FRAME WORK

6. ASSET LIABILITY MANAGEMENT • ENSURE ACCEPTABLE NII / NIM AND LONG TERM IMPROVEMENT IN NET WORTH FOR A GIVEN RISK LEVEL • INCLUDES PLANNING, ACQUIRING AND DEPLOYING FUNDS FOR ABOVE PURPOSE • IT IS ONGOING PROCESS OF FORMULATING, MONITORING, REVISING AND FRAMING STRATEGIES RELATED TO ASSETS AND LIABILITIES

7. ALM Contd… • ENCOMPASSES MANAGEMENT OF LIQUIDITY AND INTEREST RISKS • AVOIDS VOLATILITY, HELPS PRODUCT INNOVATION AND COMPLIANCE OF REGULATIONS • IN REGULATED ENVIRONMENT IT IS DAY TO DAY FUND MANAGEMENT FUNCTION ONLY

8. ALM Contd.. • FROM BALANCE SHEET ANGLE • RESERVE MAINTENANCE • LIABILITY MANAGEMENT • ASSET MANAGEMENT • INVESTMENT MANAGEMENT • CAPITAL MANAGEMENT • LIQUIDITY MANAGEMENT • FROM P&L ANGLE SPREAD MANAGEMENT

9. ALM- FUNDS MANAGEMENT • INCOME ON FUNDS LENT SHOULD BE MAXIMUM • EXPENSES ON FUNDS BORROWED SHOULD BE REASONABLE • ENNSURING FUND AVAILABILITY IS LIQUIDTY MANAGEMENT • AT REASONABLE COST IS INT. MGMT

10. LIQUIDITY MANAGEMENT • TO ENSURE SUPPLY OF NEEDED FUNDS FOR • EXISTING BUSINESS AND NEW BUSINESS • TAKE CARE OF MIS-MATACHES IN MATURITIES OF ASSETS & LIABILITIES • PROJECTS FINANCIAL STRENGTH TO SOCIETY AND BANKING SYSTEM WHICH IN TURN ENABLES EASY AVAILABILITY OF FUNDS AT REASONABLE COST

11. HOW LIQUIDITY GETS AFFECTED • DUE TO REGULATORY CHANGES • DUE MARKET CHANGES BOTH EXISTING AND POTENTIAL • DUE TO CUSTOMERS’ ACTIONS • DUE TO CRYSTALLISATION OF CONTINGENT LIABILITIES • DUE TO NPAs • BIG FRAUDS

12. LIQUIDITY MANAGEMENT • ESTIMATION OF SIZE AND TIME OF FUND REQUIREMENTS CORRECTLY • PLANNING APPROPRIATELY IN ADVANCE CONSIDERING COSTS AT DIFFERENT TIMES • ACQUIRE FUNDS AT OPTIMUM COSTS

13. LIQUIDITY MANAGEMENT • WHY CASH FLOW ESTIMATES CAN GO WRONG • DECREASE IN ANTICIPATED REALISATIONS BOTH PRINCIPAL & INT. • INCREASE IN NPA LEVELS BEYOND ESTIMATES • SUDDEN SPURT IN ASSET BEYOND BANK’S CONTROL

14. LIUQUIDITY MANAGEMENT TYPES OF RISKS IN LIQUIDITY MGMT • FUNDING RISK NEED TO PROVIDE FUNDS FOR UNEXPECTED OUTGOINGS • TIME RISK NEED FOR COMPENSATINGNON REALISED SOURCES • CALL RISK CRYSTALLISATION OF CONTINGENCIES

15. FOREIGN CURRENCY LIQUIDITY MANAGEMENT- PROCESS FINALISE STRATEGY (QUALITY& QUANTITY) FOR EACH CURRENCY OF EXPOSURE STIPULATE LIMITS FOR TOLERANCES REG. • MISMATCHES IN DIFFERENT TIME BANDS • LOAN TO DEPOSIT AND LOAN TO CAPITAL • LIQUID ASSETS TO ST LIAB. MEASURE, MONITOR AND MANAGE LIQUIDITY

16. LIQUIDITY MANAGEMENT • IDENTIFICATION OF PRIMARY AND SECONDARY RESOURCES • DIVERSIFICATIONOF RESOURCES • CRISIS SCENARIO STUDIES • CONTINGENCY PLANNING

17. DIFFERENT APPROACHES TO LIQUIDITY MANAGEMENT • STOCK APPROACH & FLOW A PPROACH • IN FLOW APPROACH INFLOWS AND OUTFLOWS ARE MEASURED FOR DIFFERENT TIME BUCKETS AND UNDER DIFFERENT SCENARIOS LIKE NORMAL TIMES, BANK SPECIFIC CRISIS AND SYSTEMIC CRISIS AND FUNDING AVENUES IDENTIFIED

18. RBI GUIDELINES • GROUP LIKELY INFLOWS AND OUTFLOWS INTO DIFFERENT TIME BUCKETS AND PRESCRIBING MAX MISMATCH IN NEAR TERM BUCKETS 1 DAY 5% 2-7 DAYS 10% 8-14 DAYS 15% 5-28 DAYS 20% PERCENTAGES ARE MAX. FOR RESPECTIVE TIME BUCKET

19. INTEREST RISK MANAGEMENT • RISK OF INT. INC. GETTING AFFECTED DUE TO EXTERNAL FACTORS ONLY • MARKET INTEREST RATES AND • REGULATORY INTEREST RATES • IMPACT WILL BE ON BOTH ADVANCES AND INVESTMENTS • LIQUIDTY AND INTEREST RISK ARE NOT EXCLUSIVE • NOT ALL ASSETS OR LIAB. WILL BE IMPACTED

20. INTEREST RISK MANAGEMENT • GAP OR MISMATCH RISK • IT IS RISK DUE TO FUNDING OF ASSETS WHICH WILL REPRICE IN DIFFERENT PERIOD FROM THAT OF LIABILITIES • BASIS RISK • DUE TO DIFFERENT IMPACT ON ASSETS AND LIABILITIES IN THE SAME TIME BUCKET

21. INTEREST RISK Contd… • EMBEDDED OPTION RISK • INHERENT RIGHT WITH AN ASSET OR LIABILITY FOR REPRICING • YIELD CURVE RISK OR RATE LEVEL RISK • DUE TO CHANGES INITIATED BY REGULATOR/ MARKET FORCES • VOLATILITY RISK • SUDDEN VOLATILITIES IN MARKT. MORE IN CASE OF BORROWED FUNDS

22. MEASUREMENT OF INTEREST RISK • GAP METHOD AND ANALYSIS • GROUP RATE SENSITIVE ASSETS AND LIABILITIES INTO DIFFERENT BUCKETS • STUDY THE IMPACT OF INTEREST CHANGES BOTH POSITIVE AND NEGATIVE ON THE NIM • DURATION METHOD • MODIFIED DURATION METHOD • SIMULATION APPROACH • STATIC AND DYNAMIC SIMULATION

23. GAP ANALYSIS • GAP IS + VE IF ASSETS > LIABILITIES Δ NII = GAP * Δr ( CHANGE IN INT. RATE) NIM = NII / EARNING ASSETS(EA) GAP * Δr = ΔNIM * EA = NIM* EA * ΔC ΔC IS ACCEPTABLE CHANGE IN NIM WORKING BACKWARDS YOU CAN ARRIVE AT THE ACCEPTABLE GAP FOR AN ACCEPTABLE ΔC

24. LIMITATIONS IN GAP METHOD • GAP MAY NOT BE AMENABLE TO CHANGE TO SUIT DESIRED ΔC • PRESUMES THAT BOTH ASSETS AND LIAB. WILL BE UNIFORMLY IMPACTED • DOESNOT TAKE INTO ACCOUNT TIME VALUE OF CASH FLOWS • WHEN THERE IS SIGNIFICANT CHANGE EVEN THOSE WHICH ARE NOT TO BE REPRICED WILL BE REPRICED

25. ADJUSTED DURATION • IN THIS METHOD ASSETS AND LIABILITIES ARE GROUPED DEPENDING UPON THEIR EXTENT OF LIKELY IMPACT AND NOT INTO TIME BUCKETS BY ASSIGNING DIFFERENT WEIGHTS • RATE ADJ. GAP = ∑ WAI* AI – ∑ WLI*LI

26. MODIFIED DURATION • MODIFIED DURATION (MD) IS USED TO STUDY THE CHANGE IN PRICE OF AN ASSET DUE TO A CHANGE IN INTEREST RATE • MD = D/ (1+ r) AND PC = - MD* Δ r / 100 PC IS CHANGE IN PRICE AND Δ r IS CHANGE IN INTEREST RATE IN BASIS POINTS AND THIS IS USEFUL ONLY IN CASE OF SMALL CHNGES IN INTEREST RATES

27. MANAGEMENT OF FOREX RISK • TRANSACTION EXPOSURE • CURRENCY RISK IN SPECIFIC FOREX TRANSACTION BETWEEN EXECUTION AND SETTLEMENT • TRANSLATION EXPOSURE • CURRECNY RISK INVOLVED AT THE TIME OF REPORTING TRANSACTIONS AT THE END OF ACCOUNTING YEAR TO H.O. • OPERATING EXPOSURE

28. FOREX RISK MGMT. TOOLS • FORWARDS • FUTURES-CURRENCY • OPTIONS • SWAPS • MONEY MARKET INSTRUMENTS • MONEYMARKETINSTRUMENTS CAN BE USED LIKE A FORWARD CONTRACT INMGMT. OF FOREX RISK

29. RISK MGMT. IN DEALING ROOM • OPEN POSITION • OVERNIGHT AND DAY LIGHT LIMITS • STOP LOSS LIMITS • CAP ON SIZE OF TRANSACTION

30. TWO PRACTICAL PROBLEMS ON DURATION ANALYSIS 1. ASSETS AND LIABILITIES OF FMG FINANCES ALONGWITH THEIR DURATION AND INTEREST RATRES ARE AS PER GIVEN TABLE. IDENTIFY RISK SENSITIVEGAP AND NIM. DURING AFORECASTING PERIOD OF 1YEAR IF INTEREST RATES FALL BY 2 % WHAT WOULD BE IMPLICATION ON NIM 2. ABC BANK HAS EARNING ASSETS AMNOUNTING TO Rs 1980 CRORES AND THEIR NIM IS 4%. MANAGEMENT’S POLICY SAYS THAT A 2.5% DEVIATION FROM NIM IS ACCEPTABLE. BANK FORECASTS THAT INTEREST RATES WOULD INCREASE BY 0.75% DURING NEXT12 MONTHS. WHAT SHOULD BE THE GAP OF THE BANK IF THEY HAVE TO BE WITHIN THE GIVEN RANGE OF NIM

31. OBJECTIVE QUESTIONS 1. THE NEED TO REPLACE NET OUTFLOWS DUE TO UNANTICIPATED WITHDRAWAL OF DEPOSITS IS KNOWN AS ---------RISK. 2. THE NEED TO COMPENSATE FOR NON-RECEIPT OF EXPECTED INFLOWS OF FUNDS IS CLASSIFIED AS -----RISK. 3. CALL RISK ARISES DUE TO CRYSTALLISATION OF ------. 4. MATURITY LADDERS ENABLES THE BANK TO ESTIMATE THE DIFFERENCE BETWEEN-----AND------IN PREDETERMINED PERIODS.

32. OBJECTIVE QUESTIONS Q. THE INSTITUTION IS IN A POSITION TO BENEFIT FROM RISING INTEREST RATES WHEN ASSETS ARE ……………THAN LIABILITIES. A. LESSER. B. GREATER C. EQUAL D. HALF. Q. THE LIQUIDITY RISK ARISING OUT OF UNANTICIPATED WITHDRAWAL OR NON RENEWAL OF DEPOSITS IS CALLED AS A. FUNDING RISK. B. TIME RISK. C. MARKET RISK D. OPERATIONAL RISK.

33. OBJECTIVE QUESTIONS Q.LIQUIDITY RISK ARISING OUT OF CRYSTALLIZATION OF LIABILITIES AND CONVERSION OF NON FUND BASED LIMITS TO FUND BASED LIMITS IS KNOWN AS A. CALL RISK. B. TIME RISK. C. OPERATIONAL RISK. D. MARKET RISK. Q. STOCK APPROACH OF MEASURING AND MANAGING LIQUIDITY RISK AND FUNDING REQUIREMENTS IS BASED ON A. LEVEL OF ASSETS AND LIABILITIES AND BALANCE SHEET EXPOSURE ON A PARTICULAR DATE. B. BASED ON STOCKS PLEDGED TO BANK IN CASH CREDIT ACCOUNT C. STOCK OF INVESTMENTS OF BANK. D. NONE OF ABOVE.

34. OBJECTIVE QUESTIONS • UNDER GAP METHOD THE NET FUNDING REQUIREMENT IS CALCULATED BASED ON A. RESIDUAL MATURITIES OF ASSETS AND LIABILITIES. B. ACTUAL MATURITIES OF ASSETS AND LIABILITIES C. BOTH THE ABOVE. D. NONE OF ABOVE. Q. CASH INFLOWS ARISE FROM MAINLY: A. MATURING ASSETS. B. MATURING LIABILITIES. C. MATURING OFF BALANCE SHEET EXPOSURE. D. MATURING TIME DEPOSITS.

35. OBJECTIVES Q. IF THERE IS SIGNIFICANT DEFICIT OBSERVED SAY AFTER 30 DAYS PERIOD OPTION AVAILABLE FOR BANK IS TO A. ACQUIRE AN ASSET MATURING ON THAT DAY. B. RENEW OR ROLL OVER A 30 DAY LIABILITY. C. ACQUIRE A LIABILITY MATURING AFTER 30 DAYS. D. NONE OF ABOVE. Q. PRESENTLY NUMBER OF SUB DIVISIONS IN 1-14 DAYS TIME BUCKET FOR STRUCTURAL LIQUIDITY ARE A. FOUR. B. THREE C. FIVE . D. NONE OF ABOVE.

36. OBJECTIVES Q. CAPITAL , RESERVES AND SURPLUS ARE SLOTTED IN WHICH TIME BUCKET IN STRUCTURAL LIQUIDITY STATEMENT: A. OVER 5 YEARS. B. OVER 3 YEARS. C. OVER 1 YEAR. D. OVER 6 MONTHS. Q. SAVING AND CURRENT DEPOSIT MAY BE TREATED AS VOLATILE PORTION UPTO A. 10% AND 15 % RESPECTIVELY. B.20% AND 30% RESPECTIVELY. C. 30% AND 40% RESPECTIVELY. D. NONE OF ABOVE

37. OBJECTIVES Q. WHAT IS BASIS RISK: A. RISK THAT INTEREST RATE OF DIFFERENT ASSETS AND LIABILITIES MAY CHANGE IN DIFFERENT MAGNITUDES IS CALLED BASIS RISK. B. RISK RELATING TO BASIS ON WHICH LOAN IS SANCTIONED. C. RISK RELATED TO YIELD CURVE. D. NONE OF ABOVE. Q. ONE OF THE STRATEGIES FOR REDUCING THE ASSET OR LIABILITY SENSITIVITY COULD BE : A. INCREASE FLOATING RATE INSTRUMENTS. B. INCREASE FIXED RATE INSTRUMENTS. C. NONE OF ABOVE. D. ALL THE ABOVE.

38. OBJECTIVES Q. HIGHER THE DURATION IMPLIES THAT A GIVEN CHANGE IN THE LEVEL OF INTEREST RATES WILL HAVE A. LARGER IMPACT ON ECONOMIC VALUE. B. SMALLER IMPACT ON ECONOMIC VALUE. C. NO IMPACT. D. NONE OF ABOVE. Q. DURATION WILL BE HIGHER IFA. LONGER THE MATURITY DATE OR SMALLER THE PAYMENTS THAT OCCUR BEFORE MATURITY ( COUPON PAYMENTS) B. SHORTER THE MATURITY AND HIGHER THE PAYMENTS THAT OCCUR BEFORE MATURITY ( COUPON PAYMENTS) C. NONE OF ABOVE. D. ALL THE ABOVE.

39. OBJECTIVES Q. SHORT TERM DYNAMIC LIQUIDITY STATEMENT RELATE TO A. MONITORING LIQUIDITY ON DYNAMIC BASIS OVER A TIME HORIZON OF 1-90 DAYS. B. MONITORING LIQUIDITY ON DYNAMIC BASIS OVER A TIME HORIZON OF 7-90 DAYS. C. MONITORING LIQUIDITY ON DYNAMIC BASIS OVER A TIME HORIZON OF 28-90 DAYS. D. NONE OF ABOVE. Q. IN STATEMENT OF INTEREST RATE SENSITIVITY : A. ONLY RUPEE ASSETS AND LIABILITIES AND OFF BALANCE SHEET POSITIONS SHOULD BE REPORTED. B. ALL ASSETS AND LIABILITIES SHOULD BE REFLECTED. C. ONLY FOREIGN CURRENCY ASSETS AND LIABILITIES SHOULD BE REFLECTED. D. NONE OF ABOVE.

40. THANQ WISH U ALL SUCCESS IN EXAM