Objective And Functions Of Asset Liability Management Committee Finance Essay

Introduction

ALM means asset liability management. ALM is defined as, “the process of decision – making to control risks of existence, stability and growth of a system through the dynamic balances of its assets and liabilities.”

ALM is the process involving decision making about the composition of assets and liabilities including off balance sheet items of the bank / FI and conducting the risk assessment.

ALM is an integral part of the financial management process of any bank. ALM is concerned with strategic balance sheet management involving risks caused by changes in the interest rates, exchange rates and the liquidity position of the bank. While managing these three risks forms the crux of ALM, credit risk and contingency risk also form a part of the ALM.

ALM of the bank has 3 important pillars that are

ALM information system

ALM organization

ALM process

ALM information system

ALM information system’s job is to gather data and latest information and evaluate this information according to their needs. Computerize system ensure that all the require data is correct and in the fast way so that they can take the decision accordingly.

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ALM organization

ALM organization means to identify the duties and structure of the members .Asset liability management committee (ALCO) is the policy and decision making component of the bank whose size depend upon the size of the bank. This is the very important department of the bank because they make the risk strategy and make sure the ALM implementation in the departments. Because ALCO is the very important and bone of the system so that’s why they need to focus on the current news, information, laws, Government rules and market situation urgently so there meeting are arranged on short interval basis to determine the exact accurate and latest picture of the situation. By gathering this data they can make the strategy according to the situation which is very helpful for the bank.

ALM process

The ALM process consist of following categories

Liquidity risk Management

Management of risk market

Funding and capital planning

Profit planning and growth projection

Trading risk management

ALM objective

Liquidity Risk Management.

Interest Rate Risk Management.

Currency Risks Management.

Profit Planning and Growth Projection

Liquidity risk Management

Liquidity risk management means bank ability to meets its liabilities as they become due .Liquidity risk refers to the risk that the institution might not be able to generate sufficient cash flow to meet its financial obligations. So there duties are to make strategy these situations and make the policies to cover these risks and if these situations arise then how the bank will arrange funds, which suitable line will be used in particular situation. Liquidity risk management make sure this situation never happened because if it happen then it could be very harmful for the bank because if they fail to arrange money the whole system could collapse, reputation could be down and whole economic system can shake so that management is very important of an organization.

Maturity Profile as given below used for measuring the future cash flows of banks in different time buckets. The time buckets given the Statutory Reserve cycle of 14 days may be distributed as under:

i) 1 to 14 days

ii) 15 to 28 days

iii) 29 days and upto 3 months

iv) Over 3 months and upto 6 months

v) Over 6 months and upto 12 months

vi) Over 1 year and upto 2 years

vii) Over 2 years and upto 5 years

viii) Over 5 years

Interest Rate Risk

It is the risk of having a negative impact on a bank’s future earnings and on the market value of its equity due to changes in interest rates

Interest rate risk is the exposure of a bank’s financial condition to adverse movements in interest rates. Accepting this risk is a normal part of banking and can be an important source of profitability and shareholder value. However, excessive interest rate risk can pose a significant threat to a bank’s earnings and capital base. Changes in interest rates affect a bank’s earnings by changing its net interest income and the level of other interest-sensitive income and operating expenses. Changes in interest rates also affect the underlying value of the bank’s assets, liabilities and off-balance sheet instruments because the resent value of future cash flows (and in some cases, the cash flows themselves) change when interest rates change. Accordingly, an effective risk management process that maintains interest rate risk within prudent levels is essential to the safety and soundness of banks.

Forex Risk

It is the risk of having losses in foreign exchange assets and liabilities due to exchanges in exchange rates among multi-currencies under consideration. Dealing is different currencies is profitable but risky as well. If the liabilities in one currency increase the level of the assets in the same currency is increase so you have to pay more so currency risk management people’s keep the eye on the market and economical activities to minimize this risk

ALCO

The Asset liability Committee (ALCO) consisting of bank senior management including the CEO for the decision of the business strategy of the bank on both asset and liability sides with the limit of the bank budget and design the best risk management objectives. The ALM desk staffs are responsible for preparing the reports and monitor the risk profile to the ALCO. They also analysie the market condition related to balance sheet and recommend the action needed to take by the bank within the budget

ALCO decision making unit responsible for

Balance Sheet planning from risk-return perspective which includes management of liquidity, interest rate and forex risks

Pricing of deposits and advances, desired maturity profile etc.

Monitoring the risk levels of the bank

Review of the results and progress of implementation of decisions made in previous meeting

Future business strategies based on bank’s current view on interest rates

To decide on source and mix of liabilities or sale of assets

To develop future direction of interest rate movements

To decide on funding mix between fixed and floating rate funds, wholesale vs. retails deposits, short term vs. long term deposits etc.

The ALCO board of directors has established both short and long-term capitalization goals to assure the ALM’s solvency and to offer members competitive deposit and loan rates. The ALCO is responsible for regularly monitoring the capitalization objectives and to report significant deviations to the board.

ALM will maintain a minimum equity capital to asset ratio of 8% to return on average net assets after regular dividends, operating expenses, net loan charge-offs, and realized investment gains/losses but before bonus dividends and incentive program payments.

ALM may complete borrowing activities in order to leverage the equity capital and increase net interest income and related net income. Borrowing activity will be carefully orchestrated to match assets and liabilities in transactions where loans or investments are purchased primarily with borrowed funds.

MANAGEMENT OF RATE RISK

The ALCO will determine the appropriate method for measuring interest rate risk within the ALM. In most cases, income simulation will be used for the analysis. The purpose of income simulation will be to test the integrity of the income stream against the normal and volatile movement of interest rates over time. ALM’s balance sheet will be modeled and tested with the goal of identifying and reducing interest rate risk. The analysis for the normal movements of interest rates will be done at least quarterly. The analysis for the volatile movements of interest rates will be done semi-annually. The ALCO may choose to contract with an outside source to perform this analysis.

The bank’s asset liability management is monitored through ALCO.

ALCO attends the following issues while managing Balance Sheet Risks:

(i) Review of actions taken in previous ALCO.

(ii) Economic and Market Status and Outlook.

(iii) Liquidity Risk related to the Balance Sheet.

(iv) Review of the price / interest rate structure.

(v) Actions to be taken.

The ALCO Process

An ALCO paper is produced every month (usually by the Finance Department) which covers various issues related to Balance Sheet risk management. The ALCO paper is prepared before the ALCO meeting as the committee reviews the ALCO paper to set strategies.

The ALCO process or the ALCO meeting reviews the ALCO paper along with the prescribed agendas. The Chairman of the committee, that is the Treasurer or the CEO, raises issues related to the balance sheet. Treasurer suggests whether the interest rates need to be reprised, whether the bank needs deposits or advance growth, whether growth of deposits and advances should be on short or longer term, what would be the transfer price of funds among the divisions, what kind of interbank dependency the bank should have etc. In short, all issues related to liquidity and market risk are covered.

Based on the analysis and views of the Treasurer, the committee takes decisions to reduce balance sheet risk while maximising profits.

Action Points

The ALCO takes decisions for implementation of any/all of the following

issues:

·€ € Need for appropriate Deposit mobilisation or Asset growth in right buckets to optimise asset-liability mismatch.

·€ € Cash flow (long/short) plan based on market interest rates and liquidity.

·€ € Need for change in Fund Transfer Pricing (FTP) &/or customer rates in

line with strategy adapted.

·€ € Address to the limits that are in breach (if any) or are in line of breach

and provide detailed plan to bring all limits under control.

·€ € Address to all regulatory issues that are under threat to non-compliance.

Special ALCO Meeting

Apart from the regular monthly meeting, ALCO meeting is also called as and

when any contingent situations arise. A very good example may be, during the any special festival. At those times, market liquidity dries out and overnight rates shoot up. Banks who are net borrowers from the market may be exposed to huge interest expense the high rates in the market. This is an ideal time for a special ALCO meeting, where the committee may take critical decisions for deposit mobilisation on an urgent basis for reducing dependency from the market.