Indian Banking Sector Reforms: Asset Liability Management System

The critical role of managing risks has now come into the open, especially against the experience of the recent East Asian crisis, where markets fell precipitously because banks and corporate did not accurately measure the risk spread that should have been reflected in their lending activities. Nor did they manage such risks or provide for them in their balance sheets. In India, the Reserve Bank has recently issued comprehensive guidelines to banks for putting in place an Asset Liability Management System. The emergence of this concept can be traced to the mid 1970s in the US when deregulation of the interest rates compelled the banks to undertake active planning for the structure of the balance sheet. The uncertainty of interest rate movements gave rise to interest rate risk thereby causing banks to look for processes to manage their risk. In the wake of interest rate risk, came liquidity risk and credit risk as inherent components of risk for banks. The recognition of these risks brought Asset Liability Management to the centre-stage of financial intermediation.

Asset Liability Management System in Banking

The Necessity of Asset Liability Management System

The asset liability management system in the Indian banks is still in its nascent stage. With the freedom obtained through reform process, the Indian banks have reached greater horizons by exploring new avenues. The government ownership of most banks resulted in a carefree attitude towards risk management. This complacent behavior of banks forced the Reserve Bank to use regulatory tactics to ensure the implementation of the ALM. Also, the post-reform banking scenario is marked by interest rate deregulation, entry of new private banks, and gamut of new products and greater use of information technology. To cope with these pressures banks were required to evolve strategies rather than ad hoc fire fighting solutions. 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.

Implementation of Asset Liability Management System (ALM)

Asset Liability Management System (ALM) framework rests on three pillars

  • ALM Organisation: The Asset-Liability Committee (ALCO) consisting of the banks senior management including CEO should be responsible for adhering to the limits set by the board as well as for deciding the business strategy of the bank in line with the banks budget and decided risk management objectives. ALCO is a decision-making unit responsible for balance sheet planning from a risk return perspective including strategic management of interest and liquidity risk. Consider the procedure for sanctioning a loan. The borrower, who approaches the bank, is appraised by the credit department on various parameters like industry prospects, operational efficiency, financial efficiency, management evaluation and others which influence the working of the client company. On the basis of this appraisal the borrower is charged certain rate of interest to cover the credit risk. For example, a client with credit appraisal AAA will be charged PLR. While somebody with BBB rating will be charged PLR + 2.5 %, say. Naturally, there will be certain cut-off for credit appraisal, below which the bank will not lend e.g. Bank will not like to lend to D rated client even at a higher rate of interest. The guidelines for the loan sanctioning procedure are decided in the ALCO meetings with targets set and goals established
  • ALM Information System: ALM Information System is used for the collection of information accurately, adequately and expeditiously. Information is the key to the ALM process. A good information system gives the bank management a complete picture of the bank’s balance sheet.
  • ALM Process: The basic ALM process involves identification, measurement and management of risk parameters. The RBI in its guidelines has asked Indian banks to use traditional techniques like Gap Analysis for monitoring interest rate and liquidity risk. However RBI is expecting Indian banks to move towards sophisticated techniques like Duration, Simulation, VaR in the future.

Is Asset Liability Management System Possible?

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 that 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 Asset Liability Management System. In the normal course, banks are exposed to credit and market risks in view of the asset-liability transformation. Banks need to address these risks in a structured manner by upgrading their risk management and adopting more comprehensive Asset Liability Management (ALM) practices than has been done hitherto.

But, ultimately risk management is a culture that has to develop from within the internal management systems of the banks. Its critical importance will come into sharp focus once current restrictions on banks portfolios are further liberalized and are subjected to the pressure of macro economic fluctuations.

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