Asset Liability Management - the Indian Perspective

Banks are exposed to many risks, including liquidity risk, interest rate risk, credit risk and operational risk. Asset liability management (ALM) is a strategic management tool to manage the interest rate risk and liquidity risk faced by banks. Banks manage the risks of asset liability by matching the assets and liabilities according to the maturity pattern or matching the duration by hedging and securitization.

Indian banks use the conventional gap reporting methodology for asset liability management for measuring interest rate risk from the earnings perspective. Gap is the measurement of the difference between risk sensitive assets and risk sensitive liabilities. In order to shift the bank’s focus to the economic value perspective and to upgrade the ALM system, the duration gap analysis was suggested by the Reserve Bank of India (RBI) in its circular of 17 April 2006. With the margin for interest rates to fluctuate over time, and the need for banks to obtain expertise in handling management information systems (MIS), it would become necessary for banks to adopt an improved ALM system and more sophisticated techniques such as the duration gap analysis.

The Duration Gap Methodology

The duration gap methodology should be implemented by calculating the modified duration of all assets and liabilities and the off-balance sheet items for a bank. Here, the weighted average duration of assets and weighted average duration of liabilities are used to measure the interest rate risk. Banks need to compute the duration gap as prescribed by the RBI.

Calculations for Duration Gap

If the duration of assets is greater than the duration of the liabilities, then a rise in the interest rate will cause the market value of equity to fall. The market value of equity denotes the long-term profits of a bank. The bank will have to minimize unfavorable movement in this value due to interest rate fluctuations. The traditional gap method ignores how changes in interest rates affect the market value of the bank’s equity.

Different Approaches to Asset Liability Analysis

The traditional analysis aims to measure the rate sensitivity of the banks’ liabilities and liabilities while the duration gap analyses the price sensitivity. While rate sensitivity is the ability to re-price the principal on the asset or liability, price sensitivity denotes the extent to which the price of the asset and liability will change or move, with respect to the change in the interest rate.

With the sophisticated approach, the bank will be in a position to assess the economic value changes to the market interest rates. The duration method acknowledges the time value of money and compares the price sensitivity of the assets with that of the liabilities to the market value of assets and liabilities. In addition, it also provides a comprehensive measure of interest rate risk for the banks’ entire portfolio of assets and liabilities.

The duration gap approach has some disadvantages as well. Firstly, the gap is difficult to calculate owing to the challenge of acquiring economic values for asset and liability instruments. Whenever the market values cannot be obtained or estimated, the present values or the book values may be used for the purpose of calculating the gap. In this regard, the gap may not yield the real economic value. Secondly, this approach does not cater to basis value risk and the risk of inserted options.

Modified duration is used for the duration gap reporting, which means the assumption that the price changes remains the same when there is a change in the rates is not always true. Duration assumes a flat yield curve and hence does not imprison the yield curve risk, which is yet another disadvantage of using this method.

The author would like to thank D. Renuka for her contribution to this article.

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