Balance Sheet Management

1. Asset liability management is concerned with strategic balance sheet management

involving risks caused by charges in interest rates, exchange rate risk and liquidity.
2. ALM is the act of planning , acquiring and directing the flow of funds through an
organisation. The ulitmate objectivity of this process is to generate adequate/stable
earnings and to steadly bulid an organisation's equity.
3. Parameters selected for the purpose of stabilising ALM are →
¤ Net interest income
¤ Net interest margin
¤ Economic equity ratio
4. NII = interest income - interest expenses
5. NIM = NII / Average total assets
6. NIM can be veiwed as the spread on earning assets.
7. At micro level objective of ALM → Price matching , Liquidity
8. At macro level objective of ALM → Formulation of critical business policies , efficient
allocation of capital and designing of products with appropriate pricing strategy.
9. ALM function can be veiwed in terms of two stage approach to balance sheet
management.
¤ Specific Balance sheet management
¤ Income - expense functions
10. Systemic risk is the risk that a default by one institution will create a " ripple effect "
that leads to default by other financial institution and threatens the stability of finacial
system.
11. Tier II elements should be limited to maximum 100% of total Tier I elements for the
purpose of compliance with the norms.
12.Tier I capital consists mainly of share capital and disclosed reserves and it is banks
highest quality capital because it is fully available to cover losses.
13. Tier II consists of certain reserves and certain types of subordinate debt. Loss
absorption capicity of Tier II capital is lower than that of Tier II.
14. Tier III capital is restricted to 250% of a banks Tier I capital.
15. The ICAAP comprises a bank's procedure and measure designed to ensure the
following→
◆ An appropriate identification and measurement of risks.
▲ An appropriate level of internal capitak in relation to the bank's risk profile.
● Application and further develpoment of suitable risk management systems in the bank.
16. ICAAP should be risk based process to mitigate the risk.
17. The first objective of an ICAAP should be risk-based process . ICAAP is to identify all
material risks such as credit risk, market risk, operational risk, interest rate risk in the
banking book(IRR BB)
18. Ther key to RAROC is the matching of revanues, costs and risk ob transaction or
portfolio basis over a defined time period.
19. RAROC is also related to → Share holder value analysis, Economic value added.
20. Interest rate risk measurment techniques
▼ Repricing schedule
▼ Gap analysis
▼ Duration
▼ Simulation approach→ a) Static simulation , b) Dynamic simulation
21. EQR( Economic equity ratio) → The ratio of the share holders funds to the total
assets measure the shifts in the ratio of owned funds to total funds.
22. RAROC methodology includes → Risk management, capital allocation , performance
management
23. The strategy for reducing the assets and liability sensitivity are → ¤Reduce asset
sensitivity
¤ Reduce liability sensitivity
24. Effects of interest rates can be studied by three prespective→ Earning prespective,
Economic perspective & embedded losses.
25. Interest risk is broadly classified into→ mismatch or gap risk , basis risk , net interest
position risk , embedded risk yield curve risk , price risk and reinvestment risk
26. RAPM = PROFIT/RC
& RC = VaR
27. Contigency planning → The capacity of bank to withstand a net funding requirement
in a bank specific or general market liquidity crisis
28. ICAAP→ Internal capital adequacy assessment process
29. Measuring and managing funding requirement can be done through two
approaches→
¤ Stock approach
¤ Flow approach
30. Stock approach→ Based on level of A&L as well as OBS exposures on a particular
date.
31. Flow approach → Net funding requirement is calculated on the basis of residual
maturities of A& L
32. Flow approach →
▪ Measuring & managing net fund requirement
▪ Managing market access
▪ Contigency planning
33. Flow approach is the basis approach being followed by indian banks. It is called gap
method of measuring and managing liquidity.
34. Other categories of liquidity risk are → funding risk, time risk,call risk
35. The objective of assets and liability management is two fold→ ensuring profitability
and ensuring liquidity.
36. Gap risk/mismatch risk → A gap or mismatch risk arises from holding A&L with
different pricipal amounts, maturity dates or repricing dates.
37. Basis risk → The risk that interest rate of different A&L may change in different
magnitude.
38. Net interest position risk → Risk arises when intetest rate earned on assets changes
while cost of funding liabilities remained same.
39. Embeded option risk → Prepayment of loans/bonds/premature closure of FD.
40. Yield curve risk → Yield curve changes depending upon thw repricing and various
other factors.
41. Price risk → Assets are sold before maturity.
42. Reinvestment risk → Uncertainty with regard to int rate at which cash flows can be
reinvested.
42. ♥ If interest rate of two different instrument change equally NII improves.
♥ If interet rate of two different instrument change unequally NII deteriorates.
43. Secured portion depending on the period for which assets has remained doubtful→
◇ upto 1 year(D1) ~ 25%
◇ 1 yr to 3 yrs (D2) ~ 40%
◇ More than 3 yrs (D3) ~ 100%
44. Basel II has stated four assessing principles for SRP→
● Banks should have reveiw for assessing their overall capital adequacy to their risk
profile and strategy for maintaing their capital levels
■ To reveiw and evaluate the banks' internal capital adequacy assessment and
strategies.
● To expect to operate above minimum regulatory capital ratios and should have the
ability to hold capital in excess of minimum.
■ To seek intervene at an early stage to prevent capital from falling below the minimum
levels required to support risk.
45. Systemic risk = ripple effect
46. Elements of Tier I capital are→
▶ Paid up capital , statutory reserves and other disclosed free reserves.
▶ Capital funds arising out of sale proceeds of assets.
◀ IPDIs limited to max 15% of Tier I
▶ PNCPs should not exceed 40% of Tier I capital.
47. Elements of Tier II capital →
◀ Revaluation reserves at a discount of 55%
▶ General provisions on std assets , floating provisions, provisions held for country
exposure, investment reserve accounts and excess provision subject to 1.25% of RWAs
48. Basel II frame work consits of three mutually reinforcing pillars→ min capital
requirement, sypervisory reveiw of capital adequacy and market discipline
49. Embedded loss → Effect /impact of past int rate change on future performance.
50. Some activities require large amounts of risk capital , which in turn requires higher
returns. This is the essence of RAROC.