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Asset Liability Management in Banks in India

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Asset Liability Management in Banks in India ASSET LIABILITY MANAGEMENT IN BANKS IN INDIA ABSTRACT THESIS SUBMITTED FOR A WARD OF THE DEGREE OF DOCTORATE IN BUSINESS ADMINISTRATION BY Rajendra Kumar Sinha UNDER THE SUPERVISION OF ^^%^^ Dr. R.A. Yadav Dr. Javaid Akhtar (External Supervisor) (Internal Supervisor) Professor Reader Faculty of Management Studies, Department of Business Administration University of Delhi, Aligarh Muslim University, Delhi Aligarh DEPARTMENT OF BUSINESS ADMINISTRATION FACULTY OF MANAGEMENT STUDIES AND RESEARCH ALIGARH MUSLIM UNIVERSITY ALIGARH - 202002 (INDIA) 2004 •4^ -- '•<•• .'. •• *T •i .f M. • ,-(1 i^ )I'^Vr"'ZTV»:!.ni,* '?^:"iC2l itf. .nil /abi^r .J:.h ;JU ' i'vI ••' ^';.;': '. ;;".ii/' J>;:-p',i ,/ : f»{.^ EXECUTIVE BRIEF ASSET LIABILITY MANAGEMENT IN BANKS IN INDIA WHAT BENEFIT DOES ALM BRING ? Assets Liability Management (ALM) is a strategic balance sheet management of risks associated with it namely credit risks, market risks (liquidity, Interest rate, currency, equity risks) and operational risks. ALM addresses the issue of defining adequate structures of the balance sheet and the hedging programmes for these risks. The mission of ALM is to provide relevant risk measures for these risks and keep them under control. The ALM Committee (ALCO) is in charge of implementing ALM decisions. WHY ALM IS IMPORTANT FOR BANKS ? Asset Liability Management (ALM) has been pushed to the forefront of today's banking landscape, because of:- - Rising global competition, - Increasing deregulation, - Introduction of innovative products and - Innovative delivery channels. In a such scenario ability to gauge the ALM risks and take appropriate position will be the key to success. ALM PRACTICES IN INDIAN BAKS While most of the banks in other economies began with strategic planning for asset liability management as early as 1970, the Indian banks did not show progress in this direction. The paradigm shift took place in 1992, with the initiation of reform processes brought about in the light of Naraslmham Committee report on financial sector reforms process. While the deregulation of interest rates and the scope for new diversified product profile gave the banks greater leeway in their operations, it also exposed the banks to greater risks. Reserve Bank of India announced prudential nomris relating to Income recognition, asset classification and provisioning and the capital adequacy nomri for the banks. These were the radical steps towards ensuring International standards in risk management by Indian banks. WHY ALM HAS BECOME A KEY MANAGEMENT AREA FOR BANKS ? The developments that have taken place since liberalisation have led to remari<able transition In the risk profile of the banks. The changes In the profile of sources and uses of funds of borrowers, the industry profile, exposure limits, interest rate structure for deposits and advances etc. have led to the discriminate pricing policies. This has, therefore, highlighted the need to match the maturities of the assets and liabilities of the banks. The significance of ALM for the banks has grown further. ALIVI PRACTICES GLOBALLY Globally, especially in the developed countries, advanced ALM risk management practices are in vogue. Various products developed by them are wide spread in use. A few popular credit risk models, used are as under:- • Portfolio Manager by KMV Corporation. This product uses Merton/Options based approach to calculating default probabilities. • Credit Metrices by JP Morgan Chase. It uses Monte Carlo simulations to measure portfolio loss distribution at the horizon date. • Credit risk by CSFB. This is based on mathematical models. Default risk is a series of continuous random variables, instead of an absolute level. This product requires lesser amount of data than the other two. The following are the different approaches employed by the banks for managing liquidity risk:- • Static Liquidity Gaps • Dynamic Liquidity Gaps • Cash Matching • Models. Two commonly used models are the Baumol Model and the Miller and Orr Model. The cash management model of Baumol extends the economic order quantity concept used in inventory management to discuss the conversion size, which influences the average cash holding of the firm. The Miller and Orr Model considers that there will be different cash balances at different periods and a firm should accordingly decide on the amount and the timing for the transfer of funds from marketable securities to cash. For hedging currency risk, various products in usage are Currency Swaps,Currency Options and Forward instruments. The risk sensitive approaches for equity positions held in banking books are emphasized in the New Basel Accord. Various products in usage are: Bond Index Swap, Equity (Index) Swap, Equity Knockout Swap, Variable Notional Swap/Option, Basket Option, Bond Option, Equity Index Participation Note, Stock Index Future, etc. In compliance to the Basel Committee' emphasis for a sound practices for identifying, monitoring and control of operational risk, the banks with international presence have been on their toe to putting in place a comprehensive risk management structure i.e. Stronger Risk Management Culture, Improved Audits and Better Audit Efficiency, Operational Risk Management Tool, Best Practices Tool for Operational Risk Management, Regulator Focus on Operational Risk Management, Operational Risk Management Structures, Corporate-level-focused approach, Internal audit group model, Key Risk Indicators (KRIs), etc. Globally active banks have been using sophisticated techniques for measuring, managing and constantly monitoring various types of ALM risks. These banks are 2 warming up for implementing the Basel II norms. Under Basel II Accord, capital allocation will be based on ttie risk intierent in ttie asset. The implementation of Basel II Accord will strengthen the regulatory review process. OBJECTIVE OF RESEARCH STUDY The objective of the study was to:- i) Analyse and evaluate the ALM practices prevalent in Public Sector Banks (PSBs) in India, ii) Make a comparative study of PSBs with Private Sector and Foreign Banks, iii) Identify gaps in ALM practices in PSBs. iv) Suggest refinement in existing ALM practices of PSBs in view.of the gaps. To help realise above objectives purview of: a) various kinds of risks associated with ALM (in the introductory chapter), b) ALM system of developed countries and c) guidelines of RBI has been done. METHODOLOGY RESEARCH DESIGN. The research involved collection of primary as well as secondary data. Primary data, especially in the context of the objective of the research project was aimed at obtaining necessary information, throwing light on the ALM practices in Public Sector Banks (PSBs) and the leading Foreign and New Generation Private Sector Banks. The available secondary data provided a macro and general view in respect of Risk Management practices including ALM In Financial Institutions. Communication mode of obtaining desired infomriation using a data-collection instrument called questionnaire was used in this research. The respondent Banks were asked to choose from a set of alternatives. The questionnaire aiming at obtaining the relevant information on ALM practices in Banks in India was administered to all 27 PSBs, top Private Sector and Foreign Banks. The actual sample of 11 PSBs, which responded to the questionnaire relating to ALM practices, are: - Randomly representing PSBs - Deposits, Advances and Total Assets/Liabilities-wlse as well these are representative sample of all PSBs - Geographically also, they are representative of country-wide sample In the light of foregoing, the sample size adequately represents the sampling frame i.e. the population elements from which it has been drawn. The Banks covered in the study are as under:- PUBLIC SECTOR BANKS HI) - Allahabad Bank - State Bank of Hyderabad Bank of Baroda - State Bank of India Bank of India - State Bank of Mysore Indian Overseas Bank - State Bank of Patiala Punjab National Bank - UCO Bank State Bank of Bikaner & Jaipur OLD PRIVATE SECTOR BANKS (2) - Bank of Rajasthan Ltd. - Karur Vysya Bank Ltd. NEW PRIVATE SECTOR BANKS (2) - HDFC Bank - ICICI Bank FOREIGN BANKS (2) - ABN Amro Bank - Standard Chartered Bank It was ensured that the data-collection instrument (questionnaire) meets the following qualifications:- - Versatility - Objectivity - Accuracy - Structured-undisguised Questionnaire. This ensured advantages in a)reliability in respondent's responses (first obtained in 2002) and when they were asked again (in the year 2003) , they responded in the similar fashion; b) securing factual infomriation like in the present research—a clear-cut reply to the questions, hence validity and reliability of fixed alternative responses has been ensured in the present case and c) in easier to tabulation and analysis of the responses obtained. In the present research, the questionnaire was sent to the designated respondents with an accompanying cover letter. The respondent Banks completed the questionnaire at their leisure and mailed it back. In the present research project, the hypothesis fonnulation (i.e. null hypothesis, Ho; alternative hypothesis Hi) was based upon the parameters of structured questionnaire, administered to the sample Banks. I. EXISTENCE OF ALCO AND A CLEARLY DEFINED ASSETS LIABILITY MANAGEMENT POLICY HQ : Public Sector Banks (PSBs) have ALCO & a well documented ALM Policy Hi : Public Sector Banks (PSBs) do not have ALCO& a well documented ALM Policy II. PERIODICITY OF HOLDING OF ALCO MEETING Ho: In PSBs, ALCO meet at least once
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