Asset Liabilities Management Hdfc 2011

A PROJECT REPORT ON “ASSEST

& LIABILITIES AND MANAGEMENT OF HDFC BANK

Project submitted in partial fulfillment for the award of degree of  MASTERS OF BUSINESS ADMINISTRATION OF JNTU

SUBMITTED BY K V RAMANAIAH H.T. NO: 10H51E0023 CMR ENGINEERING COLLEGE (Affiliated to JNTUH) Medchal Secunderabad-500014

(2010-2012)

1

DECLARATION I, the undersigned, hereby declare that the project report entitled Bank). Is my ―(Assest&liabilities and management) ‖ carried out at (HDFC Bank). original work written and submitted by me in partial fulfillment of Master`s Degree in Business Administration of ( JNTUHYDERABAD University). University).

I also

declare that this project has not been submitted earlier in any other university or institution.

Date:

(K V Ramanaiah)

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ACKNOWLEDGEMENT I take this opportunity to extend my profound thanks and deep sense of  gratitude to the authorities of ( HDFC Bank). Bank). For giving me the opportunity to undertake this project works in their esteemed organization. I profusely thank Mr. Company Guide Name (Designation) My sincere thanks to Honorable secretary Sri K Suresh, (College Name) principal Mr.------------, HOD Mr. Koteshwear Rao, and my project guide Mr. Koteshwar Rao. For the kind encouragement and constant support extended in completion of this project work. From the bottom of my heart I am also thankful to all those who have incidentally helped me, through their valued guidance, co-operation and unstinted support during the course of my project.

K V Ramanaiah

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ABSTRACT Asset-Liability Management (ALM) can be termed as a risk management technique

designed to earn an adequate return while maintaining a comfortable surplus of assets beyond liabilities. It takes into consideration interest rates, earning power, and degree of willingness to take on debt and hence is also known as Surplus Management. But in the last decade the meaning of ALM has evolved. It is now used in many different ways under different contexts. ALM, which was actually pioneered by financial institutions and banks, are now widely being used in industries too. The Society of Actuaries Task Force on ALM Principles, Canada, offers the following definition for ALM: "Asset Liability Management is the on-going process of formulating, implementing, monitoring, and revising strategies related to assets and liabilities in an attempt to achieve financial objectives for a given set of risk  tolerances and constraints." The need of the study is to concentrates on the growth and performance of The Housing Development Finance Corporation Limited (HDFC) performance by using

and to calculate the growth and

asset and liability management. And to know the management of 

nonperforming assets. To know financial position of The Housing Development Finance Corporation Limited (HDFC)

The burden of the Risk and its Costs are both manageable and transferable. Financial service firms, in the addition to managing their own risk, also sell financial risk management to others. They sell their services by bearing customers financial risks through the products they provide. A financial firm can offer a fixed-rate loan to a borrower with the risk of interest rate movements transferred from the borrower to the . Financial innovations have been concerned with risk reduction then any other subject. With the possibility of managing risk near zero, the challenge becomes not how much risk can be removed.

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INDEX

S.No:

CONTENTS

PAGE NO.

CHAPTER-1

1-13 

INTRODUCTION 

Scope of the Study



Objectives of the Study



Needs and importants



Methodology of the Study



Limitations of the Study

CHAPTER-2

14-23 

REVIEW OF LITERATURE

CHAPTER-3

24-34 

COMPANY PROFILE



INDUSTRIAL PROFILE

CHAPTER-4

35-59 

CONCEPTUAL FRAMWORK

CHAPTER-5

60-85 

DATA ANALYSIS AND INTERPRITION

CHAPTER-6

86-90    

FINDINGS CONCLUSION SUGGESTIONS BIBILIOGRAPHY

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CHAPTER-I

INTRODUCTION

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INTRODUCTION Asset Liability Management (ALM) is a strategic approach of managing the balance sheet dynamics in such a way that the net earnings are maximized. This approach is concerned with management of net interest margin to ensure that its level and riskiness are compatible with the risk return objectives. If one has to define Asset and Liability management without going into detail about its need and utility, it can be defined as simply ―management of money” which carries value and can change its shape very quickly and has an ability to come back to its original shape with or without an additional growth. The art of proper management of healthy money is ASSET AND LIABILITY MANAGEMENT (ALM

The Liberalization measures initiated in the country resulted in revolutionary changes in the sector. There was a shift in the policy approach from the traditionally administered market regime to a free market driven regime. This has put pressure on the earning capacity of cooperative, which forced them to foray into new operational areas thereby exposing themselves to new risks. As major part of funds at the disposal from outside sources, the management is concerned about  RISK  arising out of shrinkage in the value of asset, and managing such risks became critically important to them. Although co-operatives are able to mobilize deposits, major portions of it are high cost fixed deposits. Maturities of these fixed deposits were not properly matched with the maturities of assets created out of them. The tool called ASSET AND LIABILITY MANAGEMENT provides a better solution for this. ASSET LIABILITY MANAGEMENT (ALM) is a portfolio management of assets and

liability of an organization. This is a method of matching various assets with liabilities on the basis of expected rates of return and expected maturity patter n In the context of  ALM is defined as ―a process of adjusting s liability to meet loan demands, liquidity needs and safety requirements”. This will result in optimum value of the same time reducing the risks faced by them and managing the different types of risks by keeping it within acceptable levels.

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RBI revises asset liability management guidelines

February 6/2012In the era of changing interest rates, Reserve Bank of India (RBI) has now revised its Asset Liability Management guidelines. Banks have now been asked to calculate modified duration of assets (loans) and liabilities (deposits) and duration of equity. This was stated by the executive director of RBI, V K Sharma, and here today. He said that this concept gives banks a single number indicating the impact of a 1 per cent change of interest rate on its capital, captures the interest rate risk, and can thus help them move forward towards assessment of risk based capital. This approach will be a graduation from the earlier approach, which led to a mismatch between the assets and liabilities. The ED said that RBI has been laying emphasis that banks should maintain a more realistic balance sheet by giving a true picture of their non performing assets (NPAs), and they should not be deleted to show huge profits. Though the banking system in India has strong risk management architecture, initiatives have to be taken at the bank specific level as well as broader systematic level. He also emphasized on the need for sophisticated credit-scoring models for measuring the credit risks of commercial and industrial portfolios. Emphasizing on a need for an effective control system to manage risks, he said that the implementation of BASEL II norms by commercial banks should not be delayed. He said that the banks should have a robust stress testing process for assessment of capital adequacy in wake of  economic downturns, industrial downturns, market risk events and sudden shifts in liquidity conditions. Stress tests should enable the banks to assess risks more accurately and facilitate planning for appropriate capital requirements. Sharma spoke at length about the need to extend the framework of integrated risk  management to group-wide level, especially among financial conglomerates. He said that RBI has already put in place a framework for oversight of financial conglomerates, along with SEBI and IRDA. He also said that at the systematic level efforts are being made to create an enabling environment for all market participants in terms of regulation, infrastructure and instruments.

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NEED AND IMPORTANTS OF THE STUDY:

The need of the study is to concentrates on the growth and performance of HDFC and to calculate the growth and performance by using asset and liability management and to know the management of nonperforming assets.



To know financial position of HDFC



To analyze existing situation of HDFC



To improve the performance of HDFC



To analyze competition between HDFC with other cooperatives.

IMPORTANTS OF THE STUDY: Fees and Charges:-

Fees payable on the Credit Card by the Card member:The fees may vary for each Card member, and from offer to offer. The same is communicated to the Card member at the time of applying for the credit card. The above fees as applicable are billed to the card account and are stated in the card statement of the month in which it is card charged. 

Annual Fees •



Renewal Fees

Cash Advance Fees:-

The Card member can use the Card to access cash in an emergency from ATMs in India or abroad.

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SCOPE OF THE STUDY: In this study the analysis based on ratios to know asset and liabilities management under HDFC and to analyze the growth and performance of HDFC by using the calculations under asset and liability management based on ratio.



Ratio analysis



Comparative statement



Common size balance sheet.

GEOGRAPHICAL SCOPE:-

The same problem was with the all other branches of HDFC Bank even out of the pune city. The management is conducting the same research on a big ground while my contribution is tiny. Though my sample size and geographical area was defined and confine to a particular territory but the application of output from the research are going to be wide.

PRODUCT SCOPE:    

Studying the increasing business scope of the bank. Market segmentation to find the potential customers for the bank. To study how the various products are positioned in the market. Corporate marketing of products. Customers’ perception on the various products of the bank 

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OBJECTIVES OF THE STUDY



To study the concept of ASSET & LIABLITY MANAGEMENT in HDFC



To study process of CASH INFLOWS and OUTFLOWS in HDFC



To study RISK MANAGEMENT under HDFC



To study RESERVES CYCLE of ALM under HDFC



To study FUNCTIONS AND OBJECTIVES of  ALM committee.

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METHODOLOGY OF THE STUDY The study of  ALM Management is based on two factors.

1. Primary data collection.

2. Secondary data collection

PRIMARY DATA COLLECTION:

The sources of primary data were



The chief manager – ALM cell



Department Sr. manager financing & Accounting



System manager- ALM cell

Gathering the information from other managers and other officials of the organization.

SECONDARY DATA COLLECTION:

Collected from books regarding journal, and management containing relevant information about ALM and Other main sources were

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Annual report of the HDFC



Published report of the HDFC

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RBI guidelines for ALM.

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LIMITATION OF THE STUDY:



This subject is based on past data of HDFC



The analysis is based on structural liquidity statement and gap analysis.



The study is mainly based on secondary data.



Approximate results: The results are approximated, as no accurate data is Available.



Study takes into consideration only LTP and issue prices and their difference for Concluding whether an issue is overpriced or under priced leaving other.



The study is based on the issues that are listed on NSE only.

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CHAPTER-II REVIEW OF LITERATURE

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Paper Title:-Sovereign Risk and Asset and Liability Management Conceptual Issues(SRALM)  Authour:- G. Papaioannou, and Author Iva Petrova(2000) Findings:Country practices towards managing financial risks on a sovereign balance sheet continue to evolve. Each crisis period, and its legacy on sovereign balance sheets, reaffirms the need for strengthening financial risk management. This paper discusses some salient features embedded in in the current generation of sovereign asset and liability management (SALM) approaches, including objectives, definitions of relevant assets and liabilities, and methodologies used in obtaining optimal SALM outcomes. These elements are used in developing an analytical SALM framework which could become an operational instrument in formulating asset management and debtor liability management strategies at the sovereign level. From a portfolio perspective, the SALM approach could help detect direct and derived sovereign risk exposures. It allows analyzing the

financial characteristics of the balance sheet, identifying sources of costs and

risks, and quantifying the correlations among these sources of risk. The paper also outlines institutional requirements in implementing an

SALM framework and seeks to lay the ground

for further policy and analytical work on this topic.JEL

Paper Title :- Integrating Asset-Liability Risk Management with Portfolio Optimization for Individual Investors II (IALRM) Author :- Travis L. Jones, Ph.D.(2002) Findings :-

A majority of private client practitioners rely on mean-variance optimization (MVO),rules of  thumb, or model portfolios for making asset allocation recommendations. Considerations for 15

income levels and other constraints figure into the typical approach. However, not enough attention is given to the nature of an investor’s multiple time horizons and implications for cash flows. These are the future demands placed upon the portfolio. The risks that these demands will not be met need to be clearly understood in order to validate any asset allocation decision. This study presents an approach of incorporating MVO within a multi-horizon, asset-liability Management

risk model. This approach allows for cash-flow matching of a portion of an

investor’s portfolio within the optimization framework. This allows an individual’s portfolio to provide short-term cash flow, as needed, while also considering the longer-term demands on the portfolio.

Part Title :- Asset & liability management (ALM) modelling with risk control by stochastic dominance. Author name :- Xi Yang, Jacek Gondzi & Andreas Grothey(2001) Findings:An Asset Liability Management model with a novel strategy for controlling the risk of  underfunding is presented in this article. The basic model involves multi-period decisions (portfolio rebalancing) and deals with the usual uncertainty of investment returns and future liabilities. Therefore, it is well suited to a stochastic programming approach. A stochastic dominance concept is applied to control the risk of underfunding through modelling a chance constraint. A small numerical example and an out-of-sample back test are provided to demonstrate the advantages of this new model, which includes stochastic dominance constraints, over the basic model and a passive investment strategy. Adding stochastic dominance constraints comes with a price. This complicates the structure of the underlying stochastic program. Indeed, the new constraints create a link between variables associated with different scenarios of the same time stage. This destroys the usual tree structure of the constraint matrix in the stochastic program and prevents the application of standard stochastic programming approaches, such as (nested) Benders decomposition and progressive hedging. Instead, we apply a structureexploiting interior point method to this problem. The specialized interior point solver, object16

oriented parallel solver, can deal efficiently with such problems and outperforms the industrial strength commercial solver CPLEX on our test problem set. Computational results on mediumscale problems with sizes reaching about one million variables demonstrate the efficiency of the specialized solution technique. The solution time for these non-trivial asset liability models appears to grow sub linearly with the key parameters of the model, such as the number of assets and the number of realizations of the benchmark portfolio, which makes the method applicable to truly large-scale problems.

Paper Title:- An investigation of asset liability management practices in Kenya Commercial Banks(IALM) Author:- Macharia, & Irungu Peter(2003) Findings :Risk management practices in commercial banks are commonly known as asset liability management and it remains critical in ensuring safety of depositors' funds as well as investors' stake. Asset liability management is a requirement by the Central Banks of any country in order to ensure full compliance to the set risk management guidelines. This study was designed to establish the asset/liability management practices by Commercial Banks in Kenya and to find out the extent of asset-liability management by these banks. The study will be important to commercial banks, scholars and it will contribute more knowledge to the existing information on asset liability management. The population under study comprised of all Heads of Treasury Operations of the 43 Commercial Banks in Kenya. Census study was used because the population was relatively small for sampling and gave a better representation of the various risk  management practices employed by various commercial banks as well as their asset liability management practices. Each respondent filled and submitted a self administered questionnaire that was dropped and picked later. The questionnaire responses were summarized and the results analyzed using Statistical data analysis programme (SPSS) to describe the relationship between the dependent and the independent variables. Findings were presented by way of charts, graphs and tables. Several deductions were drawn from the findings. These included: responding banks 17

employed both conventional and bank-specific asset liability management practices. Most banks considered credit/default risk to be the most critical of all financial risk exposures though some empirical evidence shows that foreign exchange risk is the most critical risk for most firms. Majority of the banks did not find the Kenyan currency market to be information efficient: speculation and forecasting techniques were extensively used by most of them. Regular and systematic appraisal of asset/liability management policies was a common practice amongst most banks. Most banks also indicated that their asset/liability management systems were governed by guidelines set by the management board which is a cross functional outfit covering all the major functions in the bank this showed that ALM is a highly strategic issue in the banks Most banks, regardless of their size, extensively utilized most of the conventional hedging instruments. Micro hedge approach, accounting and economic exposure measurement strategies, natural hedging and diversification were some of the most utilized strategies. Some hedging practices were considered by most banks to be more important than others. These included use of forward contracts and foreign currency options as hedging instruments, and use of matching/natural hedging strategy.

Pper Title:- Industry - with Asset Liability Management in Indian Bankingspecial reference to Interest RateRisk Management in ICICI Bank Author:- Dr. B. Charumathi Findings:Assets and Liabilities Management (ALM) is a dynamic process of planning, organizing, coordinating and controlling the assets and liabilities  –  their mixes, volumes, maturities, yields and costs in order to achieve a specified Net Interest Income (NII). The NII is the difference between interest income and interest expenses and the basic source of banks profitability. The easing of controls on interest rates has led to higher interest rate volatility in India. Hence, there is a need to measure and monitor the interest rate exposure of Indian banks. This paper entitled ―A Study on the Assets and Liabilities Management (ALM) Practices with special reference to Interest Rate Risk Management at ICICI Bank‖ is aimed at measuring the Interest Rate Risk in ICICI Bank by using Gap Analysis Technique. Using publicly available information, this paper 18

attempts to assess the interest rate risk carried by the ICICI bank in March 2005, 2006, & 2007. The findings revealed that the bank is exposed to interest rate risk .Index Terms  — Interest volatility, risk, Indian banks

Paper

Title:-

ASSET-LIABILITY

MANAGEMENT

UNDER

BENCHMARK AND MEAN-VARIANCECRITERIA IN A JUMP DIFFUSION MARKET Author :- Yan ZENG(1), Zhongfei LI(2) Findings:Assets and Liabilities Management (ALM) is a dynamic process of planning, organizing, coordinating and controlling the assets and liabilities  –  their mixes, volumes, maturities, yields and costs in order to achieve a specified Net Interest Income (NII). The NII is the difference between interest income and interest expenses and the basic source of banks profitability. The easing of controls on interest rates has led to higher interest rate volatility in India. Hence, there is a need to measure and monitor the interest rate exposure of Indian banks. This paper entitled ―A Study on the Assets and Liabilities Management (ALM) Practices with special reference to Interest Rate Risk Management at ICICI Bank‖ is aimed at measuring the Interest Rate Risk in ICICI Bank by using Gap Analysis Technique. Using publicly available information, this paper attempts to assess the interest rate risk carried by the ICICI bank in March 2005, 2006, & 2007. The findings revealed that the bank is exposed to interest rate risk. Index Terms  — Interest volatility, risk , Indian banks

Pepar Title :- Optimal Asset Allocation in Asset Liability Management Author:- Jules H. van Binsbergen, Michael W. Brandt 19

Findings :We study the impact of regulations on the investment decisions of a defined benefits pension plan. We assess the influence of ex ante (preventive) and ex post (punitive) risk constraints on the gains to dynamic, as opposed to myopic, decision making. We find that preventive measures, such as Value-at-Risk constraints, tend to decrease the gains to dynamic investment. In contrast, punitive constraints, such as mandatory additional contributions from the sponsor when the plan becomes underfunded, lead to very large utility gains from solving the dynamic program. We also show that financial reporting rules have real effects on investment behavior. For example, the current requirement to discount liabilities at a rolling average of yields, as opposed to at current yields, induces grossly suboptimal investment decisions.

Paper Title: IMPORTANCE OF ASSET AND LIABILITY MANAGEMENT IN THE NIGERIA BANKING INDUSTRY (A CASE STUDY OF EQUITY BANK NIGERIA LIMITED) Authors:- faloye and andrew Findings :This study examines the extent to which Asset and Liability management is crucial to the existence and survival of a bank. Banking is confidence driven and the extent to which this confidence is secured and retained depends on the efficiency with which Bank asset and liabilities are managed to the satisfaction of the various constituencies that the bank serves viz: Depositors, Borrowers, Shareholders, Regulatory Authorities and the Community. The scope of  this survey is an in-depth study of the Assets and Liabilities Management in EquityBank of  Nigeria Limited in the years before re-structure (1993 to 1995) and after the re-structure (1996 to 1998). The survey will be limited to select Heads of Department and above. The survey would also cover both the surviving members of the Meridien Equity Bank, the restructuring management from Nigerian Intercontinental Merchant Bank Limited and new members of staff  after the restructure. It was found out that the crisis of confidence in the financial system and its illiquidity is traced to the macro-economic and political problems of the country. Government's 20

unsuccessful attempt to arrest the above through various measures as well as the massive looting of the treasury led to high loan defaults and exacerbated the financial crisis and the resulting mass liquidation of financial Institutions and commercial banks did not properly address the problem of effective Asset and liability management and this triggered off the bank failures already witnessed. It can therefore be concluded that effective asset and liability management is critical factor in a commercial bank. It is of utmost necessity that good asset and liability management policies should be in place in a capitalist society to mobilize available resources (liabilities) and divert them to profitable instruments (assets) to achieve bank viability and growth: Inefficient Asset and Liability Management could result in bank failure.

Paper title :-A Financial assets and liabilities management support system  Author:- Yung-Hsin Wang, Ta-Hua Kuo Findings :This paper describes the design and implementation of a decision support system (DSS) based on the fund dispatching decision viewpoint from the financial division of a business group. An integrated data warehouse is established and the technique of online analytical processing (OLAP) is applied to analyze daily transaction data of an enterprise resource planning system with determined management goal. We adopt the Business Dimensional Lifecycle approach to accomplish the system design and development. The DSS system developed is to provide latest and timely information of financial asset and liability positions in each company within the case business group so that decision makers can have a clear decision support in fund dispatching. While most related researches on fund dispatching focused especially on efficient banking capital management and few studies were done for general financial department of traditional enterprise let alone for the business group, this study has made a progress in this issue and the resultant system is applicable to the similar business group .the interest rate changing adversely, this in turn protects the owner's equity of the bank. We use seven-day's reacquired interest rate data to estimate the frequency distribution of the fluctuation of the future market rate and solved the problem to describe the fluctuation of the interest rate with multi-factors. 21

CHAPTER-III  COMPANY PROFILE

Industrial profile

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Company profile& industrial profile:A bank is a financial institution that accepts deposits and channels those deposits into lending activities. Banks primarily provide financial services to customers while enriching investors. Government restrictions on financial activities by banks vary over time and location. Banks are important players in financial markets and offer services such as investment funds and loans. In some countries such as Germany, banks have historically owned major stakes in industrial corporations while in other countries such as the United States banks are prohibited from owning non-financial companies. In Japan, banks are usually the nexus of a cross-share holding entity known as the keiretsu. In France, bancassurance is prevalent, as most banks offer insurance services (and now real estate services) to their clients. The level of  government regulation of the banking industry varies widely, with countries such as Iceland, having relatively light regulation of the banking sector, and countries such as China having a wide variety of regulations but no systematic process that can be followed typical of a communist system. The oldest bank still in existence is Monte dei Paschi di Siena, headquartered in Siena, Italy, which has been operating continuously since 1472.

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History Origin of the word:The name bank  derives from the Italian word banco "desk/bench", used during the Renaissance by Jewish Florentine bankers, who used to make their transactions above a desk  covered by a green tablecloth. However, there are traces of banking activity even in ancient times, which indicates that the word 'bank' might not necessarily come from the word 'banco'. In fact, the word traces its origins back to the Ancient Roman Empire, where moneylenders would set up their stalls in the middle of enclosed courtyards called macella on a long bench called a bancu, from which the words banco and bank  are derived. As a moneychanger, the merchant at the bancu did not so much invest money as merely convert the foreign currency into the only legal tender in Rome — that of the Imperial Mint. The earliest evidence of money-changing activity is depicted on a silver drachm coin from ancient Hellenic colony Trapezus on the Black Sea, modern Trabzon, c. 350 – 325 BC, presented in the British Museum in London. The coin shows a banker's table ( trapeza) laden with coins, a pun on the name of the city. In fact, even today in Modern Greek the word Trapeza (Τράπεζα) means both a table and a bank. Traditional banking activities:-

Banks act as payment agents by conducting checking or current accounts for customers, paying cheques drawn by customers on the bank, and collecting cheques deposited to customers' current accounts. Banks also enable customer payments via other payment methods such as telegraphic transfer, EFTPOS, and ATM.

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Banks borrow money by accepting funds deposited on current accounts, by accepting term deposits, and by issuing debt securities such as banknotes and bonds. Banks lend money by making advances to customers on current accounts, by making installment loans, and by investing in marketable debt securities and other forms of money lending. Banks provide almost all payment services, and a bank account is considered indispensable by most businesses, individuals and governments. Non-banks that provide payment services such as remittance companies are not normally considered an adequate substitute for having a bank  account. Banks borrow most funds from households and non-financial businesses, and lend most funds to households and non-financial businesses, but non-bank lenders provide a significant and in many cases adequate substitute for bank loans, and money market funds, cash management trusts and other non-bank financial institutions in many cases provide an adequate substitute to banks for lending savings to.

Entry regulation:Currently in most jurisdictions commercial banks are regulated by government entities and require a special bank licence to operate. Usually the definition of the business of banking for the purposes of regulation is extended to include acceptance of deposits, even if they are not repayable to the customer's order —  although money lending, by itself, is generally not included in the definition. Unlike most other regulated industries, the regulator is typically also a participant in the market, i.e. a government-owned (central) bank. Central banks also typically have a monopoly on the business of issuing banknotes. However, in some countries this is not the case. In the UK, for example, the Financial Services Authority licences banks, and some commercial banks (such as the Bank of Scotland) issue their own banknotes in addition to those issued by the Bank of  England, the UK government's central bank.

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Definition:The definition of a bank varies from country to country. Under English common law, a banker is defined as a person who carries on the business of  banking, which is specified as: 

conducting current accounts for his customers



paying cheques drawn on him, and



collecting cheques for his customers.

In most English common law jurisdictions there is a Bills of Exchange Act that codifies the law in relation to negotiable instruments, including cheques, and this Act contains a statutory definition of the term banker : banker  includes a body of persons, whether incorporated or not, who carry on the business of banking' (Section 2, Interpretation). Although this definition seems circular, it is actually functional, because it ensures that the legal basis for bank transactions such as cheques do not depend on how the bank is organised or regulated. The business of banking is in many English common law countries not defined by statute but by common law, the definition above. In other English common law jurisdictions there are statutory definitions of the business of banking or banking business. When looking at these definitions it is important to keep in minds that they are defining the business of banking for the purposes of the legislation, and not necessarily in general. In particular, most of the definitions are from legislation that has the purposes of entry regulating and supervising banks rather than regulating the actual business of banking. However, in many cases the statutory definition closely mirrors the common law one. Examples of statutory definitions: "banking business" means the business of receiving money on current or deposit account, paying and collecting cheques drawn by or paid in by customers, the making of advances to 26

customers, and includes such other business as the Authority may prescribe for the purposes of  this Act; (Banking Act (Singapore), Section 2, Interpretation).

"Banking business" means the business of either or both of the following:

receiving from the general public money on current, deposit, savings or other similar account repayable on demand or within less than [3 months] ... or w ith a period of call or notice of less than that period;



paying or collecting cheques drawn by or paid in by customers

[6]

Since the advent of  EFTPOS (Electronic Funds Transfer at Point Of Sale), direct credit, direct debit and internet banking, the cheque has lost its primacy in most banking systems as a payment instrument. This has led legal theorists to suggest that the cheque based definition should be broadened to include financial institutions that conduct current accounts for customers and enable customers to pay and be paid by third parties, even if they do not pay and collect cheques.

Accounting for bank accounts:Bank statements are accounting records produced by banks under the various accounting standards of the world. Under GAAP and IFRS there are two kinds of accounts: debit and credit. Credit accounts are Revenue, Equity and Liabilities. Debit Accounts are Assets and Expenses. This means you credit a credit account  to increase its balance, and you debit a debit account  to decrease its balance. This also means you debit your savings account every time you deposit money into it (and the account is normally in deficit), while you credit your credit card account every time you spend money from it (and the account is normally in credit). However, if you read your bank statement, it will say the opposite — that you credit your account when you deposit money and you debit it when you withdraw funds. If you have cash in 27

your account, you have a positive (or credit) balance; if you are overdrawn, you have a negative (or deficit) balance. The reason for this is that the bank, and not you, has produced the bank statement. Your savings might be  your  assets, but the bank's liability, so they are credit accounts (which should have a positive balance). Conversely, your loans are  your  liabilities but the bank's assets, so they are debit accounts (which should also have a positive balance). Where bank transactions, balances, credits and debits are discussed below, they are done so from the viewpoint of the account holder — which is traditionally what most people are used to seeing.

Economic functions:

Issue of money, in the form of banknotes and current accounts subject to cheque or payment at the customer's order. These claims on banks can act as money because they are negotiable and/or repayable on demand, and hence valued at par. They are effectively transferable by mere delivery, in the case of banknotes, or by drawing a cheque that the payee may bank or cash.



netting and settlement of payments  – banks act as both collection and paying agents for customers, participating in interbank clearing and settlement systems to collect, present, be presented with, and pay payment instruments. This enables banks to economise on reserves held for settlement of payments, since inward and outward payments offset each other. It also enables the offsetting of payment flows between geographical areas, reducing the cost of  settlement between them.



credit intermediation  – banks borrow and lend back-to-back on their own account as middle men.



credit quality improvement  – banks lend money to ordinary commercial and personal borrowers (ordinary credit quality), but are high quality borrowers. The improvement comes from diversification of the bank's assets and capital which provides a buffer to absorb losses without defaulting on its obligations. However, banknotes and deposits are generally unsecured; if the bank gets into difficulty and pledges assets as security, to rise the funding it

28

needs to continue to operate, this puts the note holders and depositors in an economically subordinated position. 

maturity transformation  – banks borrow more on demand debt and short term debt, but provide more long term loans. In other words, they borrow short and lend long. With a stronger credit quality than most other borrowers, banks can do this by aggregating issues (e.g. accepting deposits and issuing banknotes) and redemptions (e.g. withdrawals and redemptions of banknotes), maintaining reserves of cash, investing in marketable securities that can be readily converted to cash if needed, and raising replacement funding as needed from various sources (e.g. wholesale cash markets and securities markets).

Law of banking Banking law is based on a contractual analysis of the relationship between the bank  (defined above) and the customer   — defined as any entity for which the bank agrees to conduct an account. The law implies rights and obligations into this relationship as follows: 

The bank account balance is the financial position between the bank and the customer: when the account is in credit, the bank owes the balance to the customer; when the account is overdrawn, the customer owes the balance to the bank.

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The bank agrees to pay the customer's cheques up to the amount standing to the credit of  the customer's account, plus any agreed overdraft limit.

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The bank may not pay from the customer's account without a mandate from the customer, e.g. a cheque drawn by the customer.

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The bank agrees to promptly collect the cheques deposited to the customer's account as the customer's agent, and to credit the proceeds to the customer's account.

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The bank has a right to combine the customer's accounts, since each account is just an aspect of the same credit relationship.

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The bank has a lien on cheques deposited to the customer's account, to the extent that the customer is indebted to the bank.

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The bank must not disclose details of transactions through the customer's account —  unless the customer consents, there is a public duty to disclose, the bank's interests require it, or the law demands it.



The bank must not close a customer's account without reasonable notice, since cheques are outstanding in the ordinary course of business for several days.

These implied contractual terms may be modified by express agreement between the customer and the bank. The statutes and regulations in force within a particular jurisdiction may also modify the above terms and/or create new rights, obligations or limitations relevant to the bankcustomer relationship. Some types of financial institution, such as building societies and credit unions, may be partly or wholly exempt from bank licence requirements, and therefore regulated under separate rules. The requirements for the issue of a bank licence vary between jurisdictions but typically include: 

Minimum capital

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Minimum capital ratio

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'Fit and Proper' requirements for the bank's controllers, owners, directors, and/or senior officers

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Approval of the bank's business plan as being sufficiently prudent and plausible.

Types of banks:Banks' activities can be divided into retail banking, dealing directly with individuals and small businesses; business banking, providing services to mid-market business; corporate banking, directed at large business entities; private banking, providing wealth management services to high net worth individuals and families; and investment banking, relating to activities on the financial markets. Most banks are profit-making, private enterprises. However, some are owned by government, or are non-profit organizations.

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Central banks are normally government-owned and charged with quasi-regulatory responsibilities, such as supervising commercial banks, or controlling the cash interest rate. They generally provide liquidity to the banking system and act as the lender of last resort in event of a crisis.

Types of retail banks:

Commercial bank: the term used for a normal bank to distinguish it from an investment bank. After the Great Depression, the U.S. Congress required that banks only engage in banking activities, whereas investment banks were limited to capital market activities. Since the two no longer have to be under separate ownership, some use the term "commercial bank" to refer to a bank or a division of a bank that mostly deals with deposits and loans from corporations or large businesses.

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Community Banks: locally operated financial institutions that empower employees to make local decisions to serve their customers and the partners.

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Community development banks: regulated banks that provide financial services and credit to under-served markets or populations.

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Postal savings banks: savings banks associated with national postal systems.

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Private banks: banks that manage the assets of high net worth individuals.

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Offshore banks: banks located in jurisdictions with low taxation and regulation. Many offshore banks are essentially private banks.

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Savings bank: in Europe, savings banks take their roots in the 19th or sometimes even 18th century. Their original objective was to provide easily accessible savings products to all strata of the population. In some countries, savings banks were created on public initiative; in others, socially committed individuals created foundations to put in place the necessary infrastructure. Nowadays, European savings banks have kept their focus on retail banking: payments, savings products, credits and insurances for individuals or small and medium-sized enterprises. Apart from this retail focus, they also differ from commercial banks by their broadly decentralised distribution network, providing local 31

and regional outreach — and by their socially responsible approach to business and society. 

Building societies and Landesbanks: institutions that conduct retail banking.



Ethical banks: banks that prioritize the transparency of all operations and make only what they consider to be socially-responsible investments.



Islamic banks: Banks that transact according to Islamic principles.

Types of investment banks:

Investment banks "underwrite" (guarantee the sale of) stock and bond issues, trade for their own accounts, make markets, and advise corporations on capital market activities such as mergers and acquisitions.



Merchant banks were traditionally banks which engaged in trade finance. The modern definition, however, refers to banks which provide capital to firms in the form of shares rather than loans. Unlike venture capital firms, they tend not to invest in new companies.

Both combined:Universal banks, more commonly known as financial services companies, engage in several of these activities. These big banks are very diversified groups that, among other services, also distribute insurance — hence the term bancassurance, a portmanteau word combining "banque or bank" and "assurance", signifying that both banking and insurance are provided by the same corporate entity.

Other types of banks Islamic banks adhere to the concepts of  Islamic law. This form of banking revolves around several well-established principles based on Islamic canons. All banking activities must avoid interest, a concept that is forbidden in Islam. Instead, the bank earns profit (markup) and fees on the financing facilities that it extends to customers.

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Industrial profile

The Housing Development Finance Corporation Limited (HDFC):-

The Housing Development Finance Corporation Limited (HDFC) was amongst the first to receive an 'in principle' approval from the Reserve Bank of India (RBI) to set up a bank in the private sector, as part of the RBI's liberalization of the Indian Banking Industry in 1994. The bank was incorporated in August 1994 in the name of 'HDFC Bank Limited', with its registered office in Mumbai, India. HDFC Bank commenced operations as a Scheduled Commercial Bank  in January 1995.

OVERVIEW OF THE INDUSTRY HDFC is India's premier housing finance company and enjoys an impeccable track record in India as well as in international markets. Since its inception in 1977, the Corporation has maintained a consistent and healthy growth in its operations to remain the market leader in mortgages. Its outstanding loan portfolio covers well over a million dwelling units. HDFC has developed significant expertise in retail mortgage loans to different market segments and also has a large corporate client base for its housing related credit facilities. With its experience in the financial markets, a strong market reputation, large shareholder base and unique consumer franchise, HDFC was ideally positioned to promote a bank in the Indian environment. As on 31st December, 2009 the authorized share capital of the Bank is Rs. 550 crore. The paid-up capital as on said date is Rs. 455,23,65,640/- (45,52,36,564 equity shares of Rs. 10/each). The HDFC Group holds 23.87 % of the Bank's equity and about 16.94 % of the equity is held by the ADS Depository (in respect of the bank's American Depository Shares (ADS) Issue). 27.46 % of the equity is held by Foreign Institutional Investors (FIIs) and the Bank has about 4,58,683 shareholders. The shares are listed on the Bombay Stock Exchange Limited and The National Stock  Exchange of India Limited. The Bank's American Depository Shares (ADS) are listed on the 33

New York Stock Exchange (NYSE) under the symbol 'HDB' and the Bank's Global Depository Receipts (GDRs) are listed on Luxembourg Stock Exchange under ISIN No US40415F2002. Mr. Jagdish Capoor took over as the bank's Chairman in July 2001. Prior to this, Mr. Capoor was Deputy Governor of the RBI

MANAGEMENT The Managing Director, Mr. Aditya Puri, has been a professional banker for over 25 years, and before joining HDFC Bank in 1994 was heading Citibank's operations in Malaysia.The Bank's Board of Directors is composed of eminent individuals with a wealth of experience in public policy, administration, industry and commercial banking. Senior executives representing HDFC are also on the Board. Senior banking professionals with substantial experience in India and abroad head various businesses and functions and report to the Managing Director. Given the professional expertise of the management team and the overall focus on recruiting and retaining the best talent in the industry, the bank believes that its people are a significant competitive strength.

BOARD OF DIRECTORS 

Mr. Jagdish Capoor, Chairman

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Mr. Keki Mistry

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Mrs. Renu Karnad

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Mr. Arvind Pande

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Mr. Ashim Samanta



Mr. Chander Mohan Vasudev



Mr. Gautam Divan



Dr. Pandit Palande



Mr. Aditya Puri, Managing Director

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

Mr. Harish Engineer, Executive Director



Mr. Paresh Sukthankar, Executive Director



Mr. Vineet Jain (upto 27.12.2008)

REGISTERED OFFICE:-

HDFC Bank House, Senapati Bapat Marg, Lower Parel, Website: www.hdfcbank.com HDFC Bank offers a wide range of commercial and transactional banking services and treasury products to wholesale and retail customers. The bank has three key business segments

Wholesale Banking Services:The Bank's target market ranges from large, blue-chip manufacturing companies in the Indian corporate to small & mid-sized corporates and agri-based businesses. For these customers, the Bank provides a wide range of commercial and transactional banking services, including working capital finance, trade services, transactional services, cash management, etc. The bank is also a leading provider of structured solutions, which combine cash management services with vendor and distributor finance for facilitating superior supply chain management for its corporate customers. Based on its superior product delivery / service levels and strong customer orientation, the Bank has made significant inroads into the banking consortia of a number of  leading Indian corporates including multinationals, companies from the domestic business houses and prime public sector companies. It is recognised as a leading provider of cash management and transactional banking solutions to corporate customers, mutual funds, stock  exchange members and banks.

35

Retail Banking Services:The objective of the Retail Bank is to provide its target market customers a full range of  financial products and banking services, giving the customer a one-stop window for all his/her banking requirements. The products are backed by world-class service and delivered to customers through the growing branch network, as well as through alternative delivery channels like ATMs, Phone Banking, NetBanking and Mobile Banking. The HDFC Bank Preferred program for high net worth individuals, the HDFC Bank Plus and the Investment Advisory Services programs have been designed keeping in mind needs of  customers who seek distinct financial solutions, information and advice on various investment avenues. The Bank also has a wide array of retail loan products including Auto Loans, Loans against marketable securities, Personal Loans and Loans for Two-wheelers. It is also a leading provider of Depository Participant (DP) services for retail customers, providing customers the facility to hold their investments in electronic form. HDFC Bank was the first bank in India to launch an International Debit Card in association with VISA (VISA Electron) and issues the Mastercard Maestro debit card as well. The Bank  launched its credit card business in late 2001. By March 2009, the bank had a total card base (debit and credit cards) of over 13 million. The Bank is also one of the leading players in the ―merchant acquiring‖ business with over 70,000 Point-of-sale (POS) terminals for debit / credit cards acceptance at merchant establishments. The Bank is well positioned as a leader in various net based B2C opportunities including a wide range of internet banking services for Fixed Deposits, Loans, Bill Payments, etc.

Treasury:-

Within this business, the bank has three main product areas - Foreign Exchange and Derivatives, Local Currency Money Market & Debt Securities, and Equities. With the liberalisation of the financial markets in India, corporates need more sophisticated risk  management information, advice and product structures. These and fine pricing on various

36

treasury products are provided through the bank's Treasury team. To comply with statutory reserve requirements, the bank is required to hold 25% of its deposits in government securities.

Awards and Achievements - Banking Services:-

2011 - Best Bank - Runner Up

Outlook Money Best Bank Award 2011 Best Commercial Vehicle Financier

- Driving Positive Change

Businessworld Best Bank award

- Best Bank

BCI Continuity & Resilience Award

- Most Effective Recovery of the Year

Financial Express Best Bank Survey 2010-11

- Best in Strength and Soundness - 2nd Best in the Private Sector

CNBC TV18's Best Bank & Financial Institution Awards

- Best Bank - Mr. Aditya Puri, Outstanding Finance Professional

Dun & Bradstreet Banking Awards 2011

Best Private Sector Bank - SME Financing

ISACA 2011 award for IT Governance

Best practices in IT Governance and IT Security

IBA Productivity Excellence Awards 2011

New Channel Adopter (Private Sector)

DSCI (Data Security in Bank Security Council of  India) Excellence Awards 2011 Euromoney Awards Best Bank in India for Excellence 2011

37

FINANCE ASIA Country Awards 2011: India

- BEST BANK - BEST CASH MANAGEMENT BANK - BEST TRADE FINANCE BANK

Asian Banker

Strongest Bank in Asia Pacific

BloombergUTV's Financial Leadership Awards 2011

Best Bank

IBA Banking Technology Awards 2010

Winner 1) Technology Bank of the Year 2) Best Online Bank 3) Best Customer Initiative 4) Best Use of Business Intelligence 5) Best Risk Management System Runners Up Best Financial Inclusion

IDC FIIA Awards 2011

Excellence in Customer Experience

2010 Global Finance Award

Best Trade Finance Provider in India for 2010

2 Banking Technology Awards 2009

1) Best Risk Management Initiative and 2) Best Use of Business Intelligence.

SPJIMR Marketing Impact Awards (SMIA) 2010

2nd Prize

Business Today Best Employer Survey

Listed in top 10 Best Employers in the country

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Corporate Governance:The bank was among the first four companies, which subjected itself to a Corporate Governance and Value Creation (GVC) rating by the rating agency, The Credit Rating Information Services of India Limited (CRISIL). The rating provides an independent assessment of an entity's current performance and an expectation on its "balanced value creation and corporate governance practices" in future. The bank has been assigned a 'CRISIL GVC Level 1' rating, which indicates that the bank's capability with respect to wealth creation for all its stakeholders while adopting sound corporate governance practices is the highest.We are aware that all these awards are mere milestones in the continuing, never-ending journey of providing excellent service to our customers. We are confident, however, that with your feedback and support, we will be able to maintain and improve our services.

Technology:-

HDFC Bank operates in a highly automated environment in terms of information technology and communication systems. All the bank's branches have online connectivity, which enables the bank to offer speedy funds transfer facilities to its customers. Multi-branch access is also provided to retail customers through the branch network and Automated Teller Machines (ATMs).

The Bank has made substantial efforts and investments in acquiring the best technology available internationally, to build the infrastructure for a world class bank. The Bank's business is supported by scalable and robust systems which ensure that our clients always get the finest services we offer. The Bank has prioritised its engagement in technology and the internet as one of its key goals and has already made significant progress in web-enabling its core businesses. In each of its businesses, the Bank has succeeded in leveraging its market position, expertise and technology to create a competitive advantage and build market share.

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Mission and Business Strategy:-

Our mission is to be "a World Class Indian Bank", benchmarking ourselves against international standards and best practices in terms of product offerings, technology, service levels, risk management and audit & compliance. The objective is to build sound customer franchises across distinct businesses so as to be a preferred provider of banking services for target retail and wholesale customer segments, and to achieve a healthy growth in profitability, consistent with the Bank's risk appetite. We are committed to do this while ensuring the highest levels of ethical standards, professional integrity, corporate governance and regulatory compliance. Our business strategy emphasizes the following : 

Increase our market share in India’s expanding banking and fina ncial services industry by

following a disciplined growth strategy focusing on quality and not on quantity and delivering high quality customer service.

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Leverage our technology platform and open scaleable systems to deliver more products to more customers and to control operat ing costs.

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Maintain our current high standards for asset quality through disciplined credit risk management.



Develop innovative products and services that attract our targeted customers and address inefficiencies in the Indian financial sector.



Continue to develop products and services that reduce our cost of funds.



Focus on high earnings growth with low volatility.

HDFC Bank is headquartered in Mumbai. The Bank at present has an enviable network of  1,725 branches spread in 771 cities across India. All branches are linked on an online real-time

40

basis. Customers in over 500 locations are also serviced through Telephone Banking. The Bank's expansion plans take into account the need to have a presence in all major industrial and commercial centres where its corporate customers are located as well as the need to build a strong retail customer base for both deposits and loan products. Being a clearing/settlement bank  to various leading stock exchanges, the Bank has branches in the centres where the NSE/BSE have a strong and active member base. The Bank also has 3,898 networked ATMs across these cities. Moreover, HDFC Bank's ATM network can be accessed by all domestic and international Visa/MasterCard, Visa Electron/Maestro, Plus/Cirrus and American Express Credit/Charge cardholders.

AIMS: 

Continuous effort to improving the services.

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Evaluating individual skill trough training and motivations.

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Total involvement through participant’s management activities.

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Creating healthy and safe environment.

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Social development.

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CHAPTER-IV

CONCEPTUAL FRAMWORK

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ASSET LIABILITY MANAGEMENT (ALM) SYSTEM:Asset-Liability Management (ALM) can be termed as a risk management technique designed to earn an adequate return while maintaining a comfortable surplus of assets beyond liabilities. It takes into consideration interest rates, earning power, and degree of willingness to take on debt and hence is also known as Surplus Management. But in the last decade the meaning of ALM has evolved. It is now used in many different ways under different contexts. ALM, which was actually pioneered by financial institutions and banks, are now widely being used in industries too. The Society of Actuaries Task Force on ALM Principles, Canada, offers the following definition for ALM: "Asset Liability Management is the on-going process of formulating, implementing, monitoring, and revising strategies related to assets and liabilities in an attempt to achieve financial objectives for a given set of risk  tolerances and constraints."

Basis of Asset-Liability Management Traditionally, banks and insurance companies used accrual system of accounting for all their assets and liabilities. They would take on liabilities - such as deposits, life insurance 43

policies or annuities. They would then invest the proceeds from these liabilities in assets such as loans, bonds or real estate. All these assets and liabilities were held at book value. Doing so disguised possible risks arising from how the assets and liabilities were structured. Consider a bank that borrows 1 Crore (100 Lakhs) at 6 % for a year and lends the same money at 7 % to a highly rated borrower for 5 years. The net transaction appears profitable-the bank is earning a 100 basis point spread - but it entails considerable risk. At the end of a year, the bank will have to find new financing for the loan, which will have 4 more years before it matures. If interest rates have risen, the bank may have to pay a higher rate of interest on the new financing than the fixed 7 % it is earning on its loan. Suppose, at the end of a year, an applicable 4-year interest rate is 8 %. The bank is in serious trouble. It is going to earn 7 % on its loan but would have to pay 8 % on its financing. Accrual accounting does not recognize this problem. Based upon accrual accounting, the bank  would earn Rs 100,000 in the first year although in the preceding years it is going to incur a loss. The problem in this example was caused by a mismatch between assets and liabilities. Prior to the 1970's, such mismatches tended not to be a significant problem. Interest rates in developed countries experienced only modest fluctuations, so losses due to asset-liability mismatches were small or trivial. Many firms intentionally mismatched their balance sheets and as yield curves were generally upward sloping, banks could earn a spread by borrowing short and lending long. Things started to change in the 1970s, which ushered in a period of volatile interest rates that continued till the early 1980s. US regulations which had capped the interest rates so that banks could pay depositors, was abandoned which led to a migration of dollar deposit overseas. Managers of many firms, who were accustomed to thinking in terms of accrual accounting, were slow to recognize this emerging risk. Some firms suffered staggering losses. Because the firms used accrual accounting, it resulted in more of crippled balance sheets than bankruptcies. Firms had no options but to accrue the losses over a subsequent period of 5 to 10 years. One example, which drew attention, was that of US mutual life insurance company "The Equitable." During the early 1980s, as the USD yield curve was inverted with short-term interest 44

rates sky rocketing, the company sold a number of long-term Guaranteed Interest Contracts (GICs) guaranteeing rates of around 16% for periods up to 10 years. Equitable then invested the assets short-term to earn the high interest rates guaranteed on the contracts. But short-term interest rates soon came down. When the Equitable had to reinvest, it couldn't get even close to the interest rates it was paying on the GICs. The firm was crippled. Eventually, it had to demutualize and was acquired by the Axa Group. Increasingly banks and asset management companies started to focus on Asset-Liability Risk. The problem was not that the value of assets might fall or that the value of liabilities might rise. It was that capital might be depleted by narrowing of the difference between assets and liabilities and that the values of assets and liabilities might fail to move in tandem. Asset-liability risk is predominantly a leveraged form of risk. The capital of most financial institutions is small relative to the firm's assets or liabilities, and so small percentage changes in assets or liabilities can translate into large percentage changes in capital. Accrual accounting could disguise the problem by deferring losses into the future, but it could not solve the problem. Firms responded by forming asset-liability management (ALM) departments to assess these asset-liability risk.

Techniques for assessing Asset-Liability Risk:Techniques for assessing asset-liability risk came to include Gap Analysis and Duration Analysis. These facilitated techniques of managing gaps and matching duration of assets and liabilities. Both approaches worked well if assets and liabilities comprised fixed cash flows. But cases of callable debts, home loans and mortgages which included options of prepayment and floating rates, posed problems that gap analysis could not address. Duration analysis could address these in theory, but implementing sufficiently sophisticated duration measures was problematic. Accordingly, banks and insurance companies started using Scenario Analysis. Under this technique assumptions were made on various conditions, for example: -

45



Several interest rate scenarios were specified for the next 5 or 10 years. These specified conditions like declining rates, rising rates, a gradual decrease in rates followed by a sudden rise, etc. Ten or twenty scenarios could be specified in all.



Assumptions were made about the performance of assets and liabilities under each scenario. They included prepayment rates on mortgages or surrender rates on insurance products.



Assumptions were also made about the firm's performance-the rates at which new business would be acquired for various products, demand for the product etc.



Market conditions and economic factors like inflation rates and industrial cycles were also included.

Based upon these assumptions, the performance of the firm's balance sheet could be projected under each scenario. If projected performance was poor under specific scenarios, the ALM committee would adjust assets or liabilities to address the indicated exposure. Let us consider the procedure for sanctioning a commercial loan. The borrower, who approaches the bank, has to appraise the banks credit department on various parameters like industry prospects, operational efficiency, financial efficiency, management qualities and other things, which would influence the working of the company. On the basis of this appraisal, the banks would then prepare a credit-grading sheet after covering all the aspects of the company and the business in which the company is in. Then the borrower would then be charged a certain rate of interest, which would cover the risk of lending. But the main shortcoming of scenario analysis was that, it was highly dependent on the choice of scenarios. It also required that many assumptions were to be made about how specific assets or liabilities will perform under specific scenarios. Gradually the firms recognized a potential for different type of risks, which was overlooked in ALM analyses. Also the deregulation of the interest rates in US in mid 70 s 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 this risk. 46

In the wake of interest rate risk came Liquidity Risk and Credit Risk, which became inherent components of risk for banks. The recognition of these risks brought Asset Liability Management to the centre-stage of financial intermediation. Today even Equity Risk, which until a few years ago was given only honorary mention in all but a few company ALM reports, is now an indispensable part of ALM for most companies. Some companies have gone even further to include Counterparty Credit Risk, Sovereign Risk, as well as Product Design and Pricing Risk as part of their overall ALM. Now a day's a company has different reasons for doing ALM. While some companies view ALM as a compliance and risk mitigation exercise, others have started using ALM as strategic framework to achieve the company's financial objectives. Some of the business reasons companies now state for implementing an effective ALM framework include gaining competitive advantage and increasing the value of the organization.

Asset-Liability Management Approach:ALM in its most apparent sense is based on funds management. Funds management represents the core of sound bank planning and financial management. Although funding practices, techniques, and norms have been revised substantially in recent years, it is not a new concept. Funds management is the process of managing the spread between interest earned and interest paid while ensuring adequate liquidity. Therefore, funds management has following three components, which have been discussed briefly.

Liquidity Management:Liquidity represents the ability to accommodate decreases in liabilities and to fund increases in assets. An organization has adequate liquidity when it can obtain sufficient funds, either by increasing liabilities or by converting assets, promptly and at a reasonable cost. Liquidity is essential in all organizations to compensate for expected and unexpected balance sheet fluctuations and to provide funds for growth. The price of liquidity is a function of market conditions and market perception of the risks, both interest rate and credit risks, reflected in the 47

balance sheet and off-balance sheet activities in the case of a bank. If liquidity needs are not met through liquid asset holdings, a bank may be forced to restructure or acquire additional liabilities under adverse market conditions. Liquidity exposure can stem from both internally (institutionspecific) and externally generated factors. Sound liquidity risk management should address both types of exposure. External liquidity risks can be geographic, systemic or instrument-specific. Internal liquidity risk relates largely to the perception of an institution in its various markets: local, regional, national or international. Determination of the adequacy of a bank's liquidity position depends upon an analysis of its: 

Historical funding requirements



Current liquidity position



Anticipated future funding needs



Sources of funds



Present and anticipated asset quality



Present and future earnings capacity



Present and planned capital position

As all banks are affected by changes in the economic climate, the monitoring of economic and money market trends is key to liquidity planning. Sound financial management can minimize the negative effects of these trends while accentuating the positive ones. Management must also have an effective contingency plan that identifies minimum and maximum liquidity needs and weighs alternative courses of action designed to meet those needs. The cost of maintaining liquidity is another important prerogative. An institution that maintains a strong liquidity position may do so at the opportunity cost of generating higher earnings. The amount of liquid assets a bank should hold depends on the stability of its deposit structure and the potential for rapid expansion of its loan portfolio. If deposit accounts are composed primarily of small stable accounts, a relatively low allowance for liquidity is necessary. Additionally, management must consider the current ratings by regulatory and rating agencies when planning liquidity needs. Once liquidity needs have been determined,

48

management must decide how to meet them through asset management, liability management, or a combination of both.

Asset Management:Many banks (primarily the smaller ones) tend to have little influence over the size of their total assets. Liquid assets enable a bank to provide funds to satisfy increased demand for loans. But banks, which rely solely on asset management, concentrate on adjusting the price and availability of credit and the level of liquid assets. However, assets that are often assumed to be liquid are sometimes difficult to liquidate. For example, investment securities may be pledged against public deposits or repurchase agreements, or may be heavily depreciated because of  interest rate changes. Furthermore, the holding of liquid assets for liquidity purposes is less attractive because of thin profit spreads. Asset liquidity, or how "salable" the bank's assets are in terms of both time and cost, is of  primary importance in asset management. To maximize profitability, management must carefully weigh the full return on liquid assets (yield plus liquidity value) against the higher return associated with less liquid assets. Income derived from higher yielding assets may be offset if a forced sale, at less than book value, is necessary because of adverse balance sheet fluctuations. Seasonal, cyclical, or other factors may cause aggregate outstanding loans and deposits to move in opposite directions and result in loan demand, which exceeds available deposit funds. A bank relying strictly on asset management would restrict loan growth to that which could be supported by available deposits. The decision whether or not to use liability sources should be based on a complete analysis of seasonal, cyclical, and other factors, and the costs involved. In addition to supplementing asset liquidity, liability sources of liquidity may serve as an alternative even when asset sources are available.

Liability Management:Liquidity needs can be met through the discretionary acquisition of funds on the basis of  interest rate competition. This does not preclude the option of selling assets to meet funding 49

needs, and conceptually, the availability of asset and liability options should result in a lower liquidity maintenance cost. The alternative costs of available discretionary liabilities can be compared to the opportunity cost of selling various assets. The major difference between liquidity in larger banks and in smaller banks is that larger banks are better able to control the level and composition of their liabilities and assets. When funds are required, larger banks have a wider variety of options from which to select the least costly method of generating funds. The ability to obtain additional liabilities represents liquidity potential. The marginal cost of liquidity and the cost of incremental funds acquired are of paramount importance in evaluating liability sources of liquidity. Consideration must be given to such factors as the frequency with which the banks must regularly refinance maturing purchased liabilities, as well as an evaluation of the bank's ongoing ability to obtain funds under normal market conditions. The obvious difficulty in estimating the latter is that, until the bank goes to the market to borrow, it cannot determine with complete certainty that funds will be available and/or at a price, which will maintain a positive yield spread. Changes in money market conditions may cause a rapid deterioration in a bank's capacity to borrow at a favorable rate. In this context, liquidity represents the ability to attract funds in the market when needed, at a reasonable cost vis-e-vis asset yield. The access to discretionary funding sources for a bank is always a function of its position and reputation in the money markets. Although the acquisition of funds at a competitive cost has enabled many banks to meet expanding customer loan demand, misuse or improper implementation of liability management can have severe consequences. Further, liability management is not riskless. This is because concentrations in funding sources increase liquidity risk. For example, a bank relying heavily on foreign interbank deposits will experience funding problems if overseas markets perceive instability in U.S. banks or the economy. Replacing foreign source funds might be difficult and costly because the domestic market may view the bank's sudden need for funds negatively. Again over-reliance on liability management may cause a tendency to minimize holdings of  short-term securities, relax asset liquidity standards, and result in a large concentration of shortterm liabilities supporting assets of longer maturity. During times of tight money, this could cause an earnings squeeze and an illiquid condition. 50

Also if rate competition develops in the money market, a bank may incur a high cost of  funds and may elect to lower credit standards to book higher yielding loans and securities. If a bank is purchasing liabilities to support assets, which are already on its books, the higher cost of  purchased funds may result in a negative yield spread. Preoccupation with obtaining funds at the lowest possible cost, without considering maturity distribution, greatly intensifies a bank's exposure to the risk of interest rate fluctuations. That is why banks who particularly rely on wholesale funding sources, management must constantly be aware of the composition, characteristics, and diversification of its funding sources.

Procedure for Examination of Asset Liability Management :In order to determine the efficacy of Asset Liability Management one has to follow a comprehensive procedure of reviewing different aspects of internal control, funds management and financial ratio analysis. Below a step-by-step approach of ALM examination in case of a bank has been outlined.

Step 1 The bank/ financial statements and internal management reports should be reviewed to assess the asset/liability mix with particular emphasis on: 

Total liquidity position (Ratio of highly liquid assets to total assets).



Current liquidity position (Minimum ratio of highly liquid assets to demand liabilities/deposits).



Ratio of Non Performing Assets to Total Assets.



Ratio of loans to deposits.



Ratio of short-term demand deposits to total deposits.

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Ratio of long-term loans to short term demand deposits.

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Ratio of contingent liabilities for loans to total loans. 51



Ratio of pledged securities to total securities.

Step 2 It is to be determined that whether bank management adequately assesses and plans its liquidity needs and whether the bank has short-term sources of funds. This should include: Review of internal management reports on liquidity needs and sources of satisfying these needs.

Assessing the bank's ability to meet liquidity needs:Step 3 The banks future development and expansion plans, with focus on funding and liquidity management aspects has to be looked into. This entails: 

Determining whether bank management has effectively addressed the issue of need for liquid assets to funding sources on a long-term basis.



Reviewing the bank's budget projections for a certain period of time in the future.



Determining whether the bank really needs to expand its activities. What are the sources of funding for such expansion and whether there are projections of changes in the bank's asset and liability structure?



Assessing the bank's development plans and determining whether the bank will be able to attract planned funds and achieve the projected asset growth.



Determining whether the bank has included sensitivity to interest rate risk in the development of its long term funding strategy.

52

Step 4 Examining the bank's internal audit report in regards to quality and effectiveness in terms of  liquidity management

Step 5 Reviewing the bank's plan of satisfying unanticipated liquidity needs by : 

Determining whether the bank's management assessed the potential expenses that the bank will have as a result of unanticipated financial or operational problems.



Determining the alternative sources of funding liquidity and/or assets subject to necessity.



Determining the impact of the bank's liquidity management on net earnings position.

Step 6 

Preparing an Asset/Liability Management Internal Control Questionnaire which should include the following: -



Whether the board of directors has been consistent with its duties and responsibilities and included: -



A line of authority for liquidity management decisions.



A mechanism to coordinate asset and liability management decisions.



A method to identify liquidity needs and the means to meet those needs.



Guidelines for the level of liquid assets and other sources of funds in relationship to needs.



Does the planning and budgeting function consider liquidity requirements?



Are the internal management reports for liquidity management adequate in terms of  effective decision making and monitoring of decisions.



Are internal management reports concerning liquidity needs prepared regularly and reviewed as appropriate by senior management and the board of directors.

53



Whether the bank's policy of asset and liability management prohibits or defines certain restrictions for attracting borrowed means from bank related persons (organizations) in order to satisfy liquidity needs.



Does the bank's policy of asset and liability management provide for an adequate control over the position of contingent liabilities of the bank?



Is the foregoing information considered an adequate basis for evaluating internal control in that there are no significant deficiencies in areas not covered in this questionnaire that impair any controls?

Asset Liability Management in Indian Context :The post-reform banking scenario in India was marked by interest rate deregulation, entry of new private banks, and gamut of new products along with greater use of information technology. To cope with these pressures banks were required to evolve strategies rather than ad hoc solutions. Recognising the need of Asset Liability management to develop a strong and sound banking system, the RBI has come out with ALM guidelines for banks and FIs in April 1999.The Indian ALM framework rests on three pillars: -

ALM Organisation (ALCO):The ALCO or the Asset Liability Management Committee consisting of the banks senior management including the 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. The banks may also authorise their Asset-Liability Management Committee (ALCO) to fix interest rates on Deposits and Advances, subject to their reporting to the Board immediately thereafter. The banks should also fix maximum spread over the PLR with the approval of the ALCO/Board for all advances other than consumer credit.

54

ALM Information System:The ALM Information System is required 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 processes involving identification, measurement and management of risk  parameter .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. For the accrued portfolio, most Indian Private Sector banks use Gap analysis, but are gradually moving towards duration analysis. Most of the foreign banks use duration analysis and are expected to move towards advanced methods like Value at Risk for the entire balance sheet. Some foreign banks are already using VaR for the entire balance sheet. ALM has evolved since the early 1980's. Today, financial firms are increasingly using market value accounting for certain business lines. This is true of universal banks that have trading operations. Techniques of ALM have also evolved. The growth of OTC derivatives markets has facilitated a variety of hedging strategies. A significant development has been securitization, which allows firms to directly address asset-liability risk by removing assets or liabilities from their balance sheets. This not only eliminates asset-liability risk; it also frees up the balance sheet for new business. Thus, the scope of ALM activities has widened. Today, ALM departments are addressing (non-trading) foreign exchange risks as well as other risks. Also, ALM has extended to nonfinancial firms. Corporations have adopted techniques of ALM to address interest-rate exposures, liquidity risk and foreign exchange risk. They are using related techniques to address commodities risks. For example, airlines' hedging of fuel prices or manufacturers' hedging of  55

steel prices are often presented as ALM. Thus it can be safely said that Asset Liability Management will continue to grow in future and an efficient ALM technique will go a long way in managing volume, mix, maturity, rate sensitivity, quality and liquidity of the assets and liabilities so as to earn a sufficient and acceptable return on the portfolio. ALM is a comprehensive and dynamic framework for measuring, monitoring and managing the market risk  of a bank. It is the management of structure of balance sheet (liabilities and assets) in such a way that the net earning from interest is maximised within the overall riskpreference (present and future) of the institutions. The ALM functions extend to liquidly risk  management, management of market risk, trading risk management, funding and capital planning and profit planning and growth projection. Benefits of ALM - It is a tool that enables bank  managements to take business decisions in a more informed framework with an eye on the risks that bank is exposed to. It is an integrated approach to financial management, requiring simultaneous decisions about the types of amounts of financial assets and liabilities - both mix and volume - with the complexities of the financial markets in which the institution operates The concept of ALM is of recent origin in India. It has been introduced in Indian Banking industry w.e.f. 1

st

April, 1999. ALM is concerned with risk management and provides a

comprehensive and dynamic framework for measuring, monitoring and managing liquidity, interest rate, foreign exchange and equity and commodity price risks of a bank that needs to be closely integrated with the banks’ business strategy. Therefore, ALM is considered as an important tool for monitoring, measuring and managing the market risk of a bank.

With the deregulation of interest regime in India, the

Banking industry has been exposed to the market risks. To manage such risks, ALM is used so that the management is able to assess the risks and cover some of these by taking appropriate decisions. The assets and liabilities of the bank’s balance sheet are nothing but future cash inflows or  outflows. With a view to measure the liquidity and interest rate risk, banks use of maturity ladder and then calculate cumulative surplus or deficit of funds in different time slots on the basis of  statutory reserve cycle, which are termed as time buckets. 56

As a measure of liquidity management, banks are required to monitor their cumulative mismatches across all time buckets in their Statement of Structural Liquidity by establishing internal prudential limits with the approval of the Board / Management Committee.

The ALM process rests on three pillars: i.

ii.

iii.

ALM Information Systems 

Management Information Systems



Information availability, accuracy, adequacy and expediency

ALM Organization 

Structure and responsibilities



Level of top management involvement

ALM Process 

Risk parameters



Risk identification



Risk measurement



Risk management



Risk policies and tolerance levels.

As per RBI guidelines, commercial banks are to distribute the outflows/inflows in different residual maturity period known as time buckets. The Assets and Liabilities were earlier divided into 8 maturity buckets (1-14 days; 15-28 days; 29-90 days; 91-180 days; 181365 days, 1-3 years and 3-5 years and above 5 years), based on the remaining period to their maturity (also called residual maturity). All the liability figures are outflows while the asset 57

figures are inflows. In September, 2007, having regard to the international practices, the level of  sophistication of banks in India, the need for a sharper assessment of the efficacy of liquidity management and with a view to providing a stimulus for development of the term-money market, RBI revised these guidelines and it was provided that 

the banks may adopt a more granular approach to measurement of liquidity risk by splitting the first time bucket (1-14 days at present) in the Statement of Structural Liquidity into three time buckets viz., next day , 2-7 days and 8-14 days. Thus, now we have 10 time buckets.



After such an exercise, each bucket of assets is matched with the corresponding bucket of  the liabililty. When in a particular maturity bucket, the amount of maturing liabilities or assets does not match, such position is called a mismatch position, which creates liquidity surplus or liquidity crunch position and depending upon the interest rate movement, such situation may turnout to be risky for the bank.

Banks are required to monitor such

mismatches and take appropriate steps so that bank is not exposed to risks due to the interest rate movements during that period. 

The net cumulative negative mismatches during the Next day, 2-7 days, 8-14 days and 15-28 days buckets should not exceed 5 % ,10%, 15 % and 20 % of the cumulative cash outflows in the respective time buckets in order to recognise the cumulative impact on liquidity.



The Board’s of the Banks have been entrusted with the overall responsibility for the management of risks and is required to decide the risk management policy and set limits for liquidity, interest rate, foreign exchange and equity price risks.



Asset-Liability Committee (ALCO) is the top most committee to oversee the implementation of ALM system and it is to be headed by CMD or ED. ALCO considers product pricing for both deposits and advances, the desired maturity profile of the incremental assets and liabilities in addition to monitoring the risk levels of the bank. It will have to articulate current interest rates view of the bank and base its decisions for future business strategy on this view.

58

Rate Sensitive Assets & Liabilities : An asset or liability is termed as rate sensitive when 

Within the time interval under consideration, there is a cash flow,



The interest rate resets/reprices contractually during the interval,



BI changes interest rates where rates are administered and,



It is contractually pre-payable or withdrawal before the stated maturities.

Assets and liabilities which receive / pay interest that vary with a benchmark rate are repriced at pre-determined intervals and are rate sensitive at the time of re-pricing.

INTEREST RISK: The phased deregulation of interest rates and the operational flexibility given to banks in pricing most of the assets and liabilities imply the need for the banking system to hedge the Interest-Rate Risk. Interest Rate Risk is the risk where changes in market interest rates might adversely affect the Bank’s Net Interest Income. The gap report should be generated by grouping interest rate sensitive liabilities, assets and off balance sheet positions into time buckets according to residual maturity or next reprising period, whichever is earlier. Interest rates on term deposits are fixed during their currency while the advance interest rates are floating rates. The gaps on the assets and liabilities are to be identified on different time buckets from 1 – 28 days, 29 days upto 3 months and so on. The interest changes should be studied vis-a-vis the impact on profitability on different time buckets to assess the interest rate risk.

GAP ANALYSIS:The various items of rate sensitive assets and liabilities and off-balance sheet items are classified into time buckets such as 1-28 days, 29 days and upto 3 months etc. and items non-sensitive to interest based on the probable date for change in interest.The gap is the difference between Rate Sensitive Assets (RSA) and Rate Sensitive Liabilities (RSL) in various time buckets. The positive gap indicates that it has more RSAS than RSLS whereas the negative gap indicates that 59

it has more RSLS. The gap reports indicate whether the institution is in a position to benefit from rising interest rates by having a Positive Gap (RSA > RSL) or whether it is a position to benefit from declining interest rate by a negative Gap (RSL > RSA).

TOTAL FINANCIAL SERVICES FIRMS RISK :Total Risk  (Responsibility of CEO)

Business Risk

Financial Risk 

Product Market Risk

Capital Market Risk 

(Responsibility of the

(Responsibility of the

Chief Operating Officer)

Chief Financial Officer)

Credit

Interest rate

Strategic

Liquidity 60

Regulatory

currency

Operating

Settlement

Human resources

Basis Legal

PRODUCT MARKET RISK:This risk decision relate to the operating revenues and expenses of the form that impact the operating position of the profit and loss statements which include crisis, marketing, operating systems, labor cost, technology, channels of distributions at strategic focus. Product Risks relate to variations in the operating cash flows of the firm, which effect Capital Market, required Rates Of Return :



CREDIT RISK



STRATEGIC RISK



COMMODITY RISK



OPERATIVE RISK



HUMAN RESOURCES RISK



LEGAL RISK

61

Risk in Product Market relate to the operational and strategic aspects of managing operating revenues and expenses. The above types of Product Risks are explained as follows :

CREDIT RISK:The most basic of all Product Market Risk or other financial intermediary is the erosion of  value due to simple default or non-payment by the borrower. Credit risk has been around for centuries and is thought by many to be the dominant financial services t oday’s intermediate the risk appetite of lenders and essential risk ness of borrowers. manage this risk by ; 

making intelligent lending decisions so that expected risk of

borrowers is both accurately

assessed and priced; 

Diversifying across borrowers so that credit losses are not concentrated in time;



purchasing third party guarantees so that default risk is entirely or partially shifted away from lenders.

STRATEGIC RISK:This is the risk that entire lines of business may succumb to competition or obsolescence. In the language of strategic planner, commercial paper  is a substitute product for large corporate loans. Strategic risk occurs when a is not ready or able to compete in a newly developing line of  business. Early entrants enjoyed a unique advantage over newer entrants. The seemingly conservative act of waiting for the market to develop posed a risk in itself. Business risk accrues from jumping into lines of business but also from staying out too long.

COMMODITY RISK:-

62

Commodity prices affects and other lenders in complex and often unpredictable ways. The macro effect of energy price increases on inflation also contributed to a rise in interest rates, which adversely affected the value of many fixed rate financial assets. The subsequent crash in oil prices sent the process in reverse with nearly equally devastating effe.

OPERATING RISK:Machine-based system offer essential competitive advantage in reducing costs and improving quality while expanding service and speed. No element of management process has more potential for surprise than systems malfunctions. Complex, machine-based systems produce what is known as the “black box effect”. The inner working of system can become opaque to their users. Because developers do not use the system and users often have not constitutes a significant Product Market Risk. No financial service firm can small management challenge in the modern financial services company. HUMAN RESOURCES RISK:

Few risks are more complex and difficult to measure than those of personnel policy; they are  Recruitment, Training, Motivation and Retention. Risk to the value of the Non-Financial Assets

as represented by the work force represents a much more subtle of risk. Concurrent with the loss of key personal is the risk of inadequate or misplaced motivation among management personal. This human redundancy is conceptually equivalent to safety redundancy in operating systems. It is not inexpensive, but it may well be cheaper than the risk of loss. The risk and rewards of  increased attention to the human resources dimension of management are immense.

63

LEGAL RISK:This is the risk that the legal system will expropriate value from the shareholders of financial services firms. The legal landscape today is full of risks that were simply unimaginable even a few years ago. More over these risks are very hard to anticipate because they are often unrelated to prior events which are difficult and impossible to designate but the management of a financial services firm today must have these risks at least in view. They can cost millions.

CAPITAL MARKET RISK:In the Capital Market Risk decision relate to the financing and financial support of Product Market activities. The result of product market decisions must be compared to the required rate of return that results from capital market decision to determine if management is creating value. Capital market decisions affect the risk tolerance of product market decisions related to variations in value associated with different financial instruments and required rate of return in the economy.



LIQUIDITY RISK



INTEREST RATE RISK



CURRENCY RISK



SETTLEMENT RISK



BASIS RISK

64

LIQUIDITY RISK:-

For experienced financial services professionals, the foremost capital market risk is that of  inadequate liquidity to meet financial obligations. The obvious form is an inability to pay desired

withdrawals. Depositors react desperately to the mere prospect of this situation.

They can drive a financial intermediary to collapse by withdrawing funds at a rate that exceeds its capacity to pay. For most of this century, individual depositors who lost faith in ability to repay them caused failures from liquidity. Funds are deposited primarily as a  financial of rate. Such funds are called “purchased money” or “headset funds” as they are frequently

bought by employees who work on the money desk quoting rates to institutions that shop for the highest return. To check liquidity risk, firms must keep the maturity profile of the liabilities compatible with that of the assets. This balance must be close enough that a reasonable shift in interest rates across the yield curve does not threaten the safety and soundness of the entire firm.

INTEREST RATE RISK :In extreme conditions, Interest Rate fluctuations can create a liquidity crisis. The fluctuation in the prices of financial assets due to changes in interest rates can be large enough to make default risk a major threat to a financial services firm’s viability. There’s a function of both the magnitude of change in the rate and the maturity of the asset. This inadequacy of assessment and consequent mispricing of assets, combined with an accounting system that did not record unrecognized gains and losses in asset values, created a financial crisis. Risk based capital rules pertaining to have done little to mitigate the interest rate risk management problem. The decision to pass it of, however is not without large cost, so the cost benefit tradeoff becomes complex.

CURRENCY RISK:The risk of exchange rate volatility can be described as a form of basis risk among currencies instead of basis risk among interest rates on different securities. Balance sheets comprised of numerous separate currencies contain large camouflaged risks through financial reporting systems that do not require assets to be marked to market. Exchange rate risk affects 65

both the Product Markets and The Capital Markets. Ways to contain currency risk have developed in today’s derivative market through the use of swaps and forward contracts. Thus, this risk is manageable only after the most sophisticated and modern risk management technique is employed

SETTLEMENT RISK :Settlement Risk is a particular form of  default risk , which involves the competitors. Amounts settle obligations having to do with money transfer, check clearing, loan disbursement and repayment, and all other inter- transfers within the worldwide monetary system. A single payment is made at the end of the day instead of multiple payments for individual transactions.

BASIS RISK :Basis risk is a variation on the interest rate risk theme, yet it creates risks that are less easy to observe and understand. To guard against interest rate risk, somewhat non comparable securities may be used as a hedge. However, the success of this hedging depends on a steady and predictable relationship between the two no identical securities. Basis can negate the hedge partially or entirely, which vastly increases the Capital Market Risk exposure of the firm.

66

CHAPTER-V DATA ANALYSIS & INTERPRETATION

67

RISK MANAGEMENT SYSTEM Assuming and managing risk is the essence of business decision-making. Investing in a new technology, hiring a new employee, or launching a marketing campaign is all decisions with uncertain outcomes. As a result all the major management decisions of how much risk to take and how to manage the risk.

The implementation of risk management varies from business to business, from one management style to another and from one time to another. Risk management in the financial services industry is different from others. Circumstances, Institutions and Managements are different. On the other hand, an investment decision is no recent history of legal and political stability, insights into the potential hazards and opportunities.

Many risks are managed quantitatively. Risk exposure is measured by some numerical index. Risk cost tradeoff many tools are described by numerical valuation formulas.

Risk management can be integrated into a risk management system. Such a system can be utilized to manage the trading position of a small-specialized division or an entire financial institution. The modules of the system can be implemented with different degrees of accuracy and sophistication.

68

RISK MANAGEMENT SYSTEM Dynamics of risk factors

Cash flows Generator

Arbitrage Pricing Model

Price and Risk  Profile Of Contingent Claims

Dynamic Trading Rules

Risk Optimizer

69

Target Risk Profile

RISK MANAGEMENT SYSTE:Arbitrage pricing models range from simple equations to large scale numerically sophisticated algorithms. Cash flow generators also vary from a single formula to a simulator that accounts for the dependence of cash flows on the history of the risk factors.

Financial engineers are continuously incorporating advances in econometric techniques, asset pricing models, simulation techniques and optimization algorithms to produce better risk management systems.

The important ingredient of the risk management approach is the treatment of risk  factors and securities as an integrated portfolio. Analyzing the correlation among the real, financial and strategic assets of an organization leads to clear understanding of risk  exposure. Special attention is paid to risk factors, which translate to correlation among the values of securities. Identifying the correlation among the basic risk factors leads to more effective risk management.

CONCLUSION:The burden of the Risk and its Costs are both manageable and transferable. Financial service firms, in the addition to managing their own risk, also sell financial risk management to others. They sell their services by bearing customers financial risks through the products they provide. A financial firm can offer a fixed-rate loan to a borrower with the risk of interest rate movements transferred from the borrower to the. Financial innovations have been concerned with risk reduction than any other subject. With the possibility of managing risk near zero, the challenge becomes not how much risk can be removed.

Financial services involve the process of intermediation between those who have financial resources and those who need them, either as a principal or as an agent. Thus, value breaks into several distinct functions, and it includes the intermediation of the following: 70

Maturity Preference mismatch, Default, Currency Preference mis-match, Size of  transaction and Market access and information.

RISK MANAGEMENT IN HDFC:Narasimham committee II , advised to address market risk in a structured manner by st

adopting Asset and Liability Management practices with effect from April 1 1989.

Asset and liability management (ALM) is ―the Art and Science of choosing the best mix of assets for the firm’s asset portfolio and the best mix of liabilities for the firm’s liability  portfolio‖. It is particularly critical for Financial Institutions.

For a long time it was taken for granted that the liability portfolio of financial firms was beyond the control of the firm and so management concentrated its efforts on choosing the asset mix. Institutions treasury department used the funds provided by deposits to structure an asset portfolio that was appropriate for the given liability portfolio.

With the advent of Certificate of Deposits (CDs), a tool by which to manipulate the mix of  liabilities that supported their Asset portfolios, which has been one of the active management of  assets and liabilities.

Asset and liability management program evolve into a strategic tool for management, the main elements of the ALM system are: 

ALM INFORMATION.



ALM ORGANISATION.



ALM FUNCTION.

71

ALM INFORMATION:ALM is a risk management tool through which Market risk associated with business are

identified, measured and monitored to maintain profits by restructuring Assets and Liabilities. The ALM framework needs to be built on sound methodology with necessary information system as back up. Thus the information is key element to the ALM process.

There are various methods prevalent worldwide for measuring risks. These range from the simple Gap statement to extremely sophisticate and data intensive  Risk adjusted profitability measurement  (RAPM) methods. The central element for the entire ALM exercise is the

availability of adequate and accurate information.

However, the existing systems in many Indians do not generate information in manner required for the ALM. Collecting accurate data is the biggest challenge before, the particularly those having wide network of branches, but lacking full-scale computerization.

Therefore the introduction of these information systems for risk measurement and monitoring has to be addressed urgently.

The large network of branches and the lack of support system to collect information required for the ALM which analysis information on the basis of residual maturity and behavioral pattern, it would take time for s in the present state to get the requisite information.

ALM ORGANISATION:Successful implementation of the risk management process requires strong commitment on the part of senior management in the to integrate basic operations and strategic decision making with risk management. The Board of Directors should have overall responsibility for management of risk and should decide the risk management policy of the, setting limits for liquidity, interest rate, foreign exchange and equity / price risk.

72

The Asset Liability Management Committee (HDFC) consisting of the s senior management, including CEO/CMD should be responsible for ensuring adherence to the limits set by the Board of Directors as well as for deciding the business strategy of the (on the assets and liabilities sides) in line with the s budget and decided risk management objective. The ALM support group consisting of operation staff should be responsible for analyzing, monitoring and reporting the risk profiles to the HDFC. The staff should also prepare forecasts (simulations) showing the effects of various possible changes in market condition related to the balance sheet and recommend the action needed to adhere to s internal limits, The HDFC is a decision-making unit responsible for balance sheet planning from a riskreturn perspective including the strategic management of interest rate and liquidity risks. Each has to decide on the role of its HDFC, its responsibility as also the decision to be taken by it. The business and risk management strategy of the should ensure that the operates within the limits /  parameters set by the Board. The business issues that an HDFC would consider, inter alia, will include product pricing for deposits and advances, desired maturity profile and mix of the incremental Assets and Liabilities, etc. in addition to monitoring the risk levels of the , the HDFC should review the results of and progress in implementation of the decisions made in the previous meetings. The HDFC would also articulate the current interest rate view of the and base its decisions for future business strategy on this view. In respect of this funding policy, for instance, its responsibility would be to decide on source and mix of liabilities or sale of assets. Towards this end, it will have to develop a view on future direction of interest rate movements and decide on funding mixes between fixed vs. floating rate funds, wholesale vs. retail deposits, Money markets vs. Capital market funding, domestic vs. foreign currency funding etc. Individuals will have to decide the frequency for holding their HDFC meetings.

TYPICAL BUSINESS OF HDFC 

Reviewing of the impact of the regulatory changes on the industry.



Overseeing the budgetary process;

73



Reviewing the interest rate outlook for pricing of assets and liabilities (Loans and Deposits)



Deciding on the introduction of any new loan / deposit product and their impact on interest rate / exchange rate and other market risks;



Reviewing the asset and liability portfolios and the risk limits and thereby, assessing the capital adequacy;



Deciding on the desired maturity profile of incremental assets and liabilities and thereby assessing the liquidity risk; and



Reviewing the variances in actual and projected performances with regard to Net Interest Margin(NIM), spreads and other balance sheet ratios.

COMPOSITION OF HDFC:The size (number of members) of HDFC would depend on the size of each institution, business mix and organizational complexity, To ensure commitment of the Top management and timely response to market dynamics, the CEO/MD or the GM should head the committee. The chiefs of Investment, Credit, Resources Management or Planning, Funds Management / Treasury (domestic), etc., can be members of the committee. In addition, the head of the computer (technology) Division should also be an invitee for building up of MIS and related computerization. Some of may even have Sub-Committee and Support Groups.

ALM ORGANIZATION consists of following categories:



ALM BOARD



HDFC

74



ALM CELL



COMMITTEE OF DIRECT

ALM BOARD:The Board of management should have overall responsibility for management of risk  and should decide the risk management policy of the and set limits for liquidity and interest rate risks.

HDFC:The bank has constituted an Asset- Liability committee (HDFC). The committee may consist of the following members.

i) General Manager

Head of Committee

ii) General Manager (Loans & Advances)

Member

iii) General Manager (CMI & AD)

Member

iv) AGM / Head of the ALM Cell

Member

The HDFC is a decision making unit responsible for ensuring adherence to the limits set by board as well as for balance sheet planning from risk return perspective including the strategic management of interest rate and liquidity risks, in line with the s budget and decided risk  management objectives.

75

The Business issues that an HDFC would consider interalia, will include fixation of interest rates for both deposits and advances, desired maturity profile of the incremental assets and liabilities etc.

The HDFC would also articulate the current interest rate due of the and base its decisions for future business strategy on this view. In respect of funding policy, for instance, its responsibility would be decided on source and mix of liability.

Individuals will have to decide the frequency for their HDFC meetings. However, it is advised that HDFC should meet at least once in a fortnight. The HDFC should review results of  and process in implementation of the decisions made in the previous meetings

ALM CELL:The ALM desk / cell consisting of operating staff should be responsible for analyzing, monitoring and reporting the profiles to the HDFC. The staff should also prepare forecasts (simulations) showing the effects of various possible changes in market conditions related to the balance sheet and recommend the action needed to adhere to the internal limits.

COMMITTEE OF DIRECTORS :They should also constitute professional, management and supervisory committee, consisting of three to four directors, which will oversee the implementation of the ALM system, and review it’s functioning periodically.

ALM PROCESS The scope of ALM function can be described as follows:



Liquidity Risk Management 76



Interest Rate Risk Management



Currency Risk Management



Settlement Risk Management



Basis Risk Management

The RBI guidelines mainly address Liquidity Risk Management and Interest Rate Risk  Management.

The following are the concepts discussed for analysis of Asset-Liability Management under above mentioned risks.









Liquidity Risk

Maturity profiles

Interest rate risk

Gap analysis

Liquidity Risk Management:Measuring and managing liquidity needs are vital activities of the Risk. By assuring a returns ability to meet its liability as they become due, liquidity management can reduce the probability of an adverse situation development. The importance of liquidity transcends individual institutions, as liquidity shortfall in one institution can have repercussions on the entire system. 77

Liquidity risk management refers to the risk of maturing liability not finding enough maturing assets to meet these liabilities. It is the potential inability to meet the liability as they became due. This risk arises because borrows funds for different maturities in the form of  deposits, market operations etc. and lock them into assets of different maturities. Liquidity Gap also arises due to unpredictability of deposit withdrawals, changes in loan demands. Hence measuring and managing liquidity needs are vital for effective and viable operations. Liquidity measurement is quite a difficult task and usually the stock or cash flow approaches are used for its measurement. The stock approach used certain liquidity ratios. The liquidity ratios are the ideal indicators of liquidity of Operating in developed financial markets, the ratio do not reveal the real liquidity profile of s which are operating generally in a fairly illiquid market. The assets, which are commonly considered as liquid like Government securities, have limited liquidity when the market and players are in one direction. Thus analysis of liquidity involves tracking of cash flow mismatches.

The statement of structural liquidity may be prepared by placing all cash inflows and outflows in the maturity ladder according to the expected timing of cash flows.

The position of Assets and Liabilities are classified according to the maturity patterns a maturing liability will be a cash outflow while a maturing asset will be a cash inflows. The measuring of the future cash flows of s is done in different time buckets.

The time buckets, given the statutory Reserve cycle of 14 days may be distributed as under: 

1 to 14 days



15 to 28 days



29 days and up to 3 months



Over 3 months and up to 6 months



Over 6 months and up to 1 year



Over 1 year and up to 3 years



Over 3 years and up to 5 years 78

MATURITY PROFILE  –  LIQUIDITY:HEAD OF ACCOUNTS

Classification into time buckets

A.OUTFLOWS 1.Capital, Reserves and Surplus

Over 5 years bucket.

2.Demand Deposits (Current &

Demand Deposits may be classified

Savings Deposits)

into volatile and core portions, 25 % of  deposits are generally withdraw able on demand. This portion may be treated as volatile. While volatile portion may be placed in the first time bucket i.e., 1-14 days, the core portion may be placed in 1-2 years, bucket.

3. Term Deposits

Respective maturity buckets.

4. Borrowings

Respective maturity buckets.

5. Other liabilities and provisions

(i)

1-14 days bucket

(ii)

Items not representing cash

(i)

Bills Payable

(ii)

Inter-office Adjustment

payable may be placed in over 5

(iii)

Provisions for NAPs

years bucket

a) sub-standard

(iii) a) 2-5 years bucket.

b) doubtful and Loss (iv)

(v)

provisions for depreciation

.(iv)

in Investments

(v) a)

provisions for NAPs in investment

(vi)

b) Over 5 years bucket

provisions for other purposes

Over 5 years bucket. 2-5 years bucket.

b) Over 5 years bucket (vi) Respective buckets depending on the purpose.

INFLOWS

79

1. Cash

1-14 days bucket.

2. Balance with others (i)

Current Account

(i)

Non-withdraw able portion on account of stipulations of  minimum balances may be shown Less than 1-14 days bucket.

(ii)

Money at call and short Notice,

(ii)

Respective maturity buckets.

Term Deposits and other Placements 3. Investments (i)

Approved securities

(i)

Respective maturity buckets excluding the amount required to be reinvested to maintain SLR

(ii)

Corporate

(ii) Respective Maturity buckets.

Debentures

and

Investments classified as NPAs

bonds, CDs and CPs,

Should be shown under 2-5 years

redeemable

bucket (sub-standard) or over 5

preference

shares,

units

Mutual

of

years bucket (doubtful and loss). (iii) Over 5 years bucket.

Funds (close ended). Etc.

(iv)

Over 5 years bucket.

(iii) Share / Units of Mutual Funds (open ended) (iii)

Investment

in

subsidiaries /  Joint Ventures.

4. Advances (performing / standard) (i)

Bills Purchased and

(i) Respective Maturity buckets.

Discounted

(ii) they should undertake a study 80

(including bills

under

DUPN) (iii)

of behavioral and seasonal pattern of a ailments based on outstanding

Cash Credit / Overdraft

and the core and volatile portion

(including TOD) and

should be identified. While the

Demand Loan component of 

volatile portion could be shown in

Working Capital.

the respective maturity bucket. The core portion may be shown under 1-2 years bucket.

(iii)

Term Loans

(iii) Interim cash flows may be shown under respective maturity buckets.

5. NPAs a. Sub-standard

(I) 2-5 years bucket.

b. Doubtful and Loss

(ii) Over 5 years bucket.

6. Fixed Assets

Over 5 years bucket.

7. Other-office Adjustment (i)

Inter-office Adjustment

(i)

As per trend analysis, Intangible items or items not representing cash receivables may be shown in over 5 years bucket.

(ii)

Others

(i)

Respective

maturity

buckets. Intangible assets and assets not representing cash receivables may be shown in over 5 years bucket.

81

Terms used:CDs: Certificate of Deposits.

CPs: Commercial Papers. DTL PROFILE: Demand and Time Liabilities. Inter office adjustment:

Outflows: Net Credit Balances

Inflows: Net Debit Balances

Other Liabilities: Cash payables, Income received in advance, Loan Loss and

Depreciation in Investments. Other assets: Cash Receivable, Intangible Assets and Leased Assets.

Interest Rate Risk:Interest Rate Risk refers to the risk of changes in interest rates subsequent to the creation of the assets and liabilities at fixed rates. The phased deregulations of interest rates and the operational flexibility given in pricing most of the assets and liabilities imply the need for system to hedge the interest rate risk. This is a risk where changes in the market interest rates might adversely affect financial conditions.

The changes in interest rates affects in large way. The immediate impact of change in interest rates is on earnings by changing its Net Interest Income ( NII). A long term impact of  changing interest rates is on Market Value of Equity (MVE) or net worth as the economic value of assets, liabilities and off-balance sheet positions get affected due to variation in market interest rates.

The risk from the earnings perspective can be measured as changes in the Net Interest Income (NII) OR Net Interest Margin (NIM). 82

There are many analytical techniques for measurement and management of interest rate risk. In MIS of ALM, slow pace of computerization in and the absence of total deregulation, the traditional GAP ANALYSIS is considered as a suitable method to measure the interest rate risk.

Data Interpretation Gap Analysis:The Gap or mismatch risk can be measured by calculating Gaps over different time buckets as at a given date. Gap analysis measures mismatches between rate sensitive liabilities

and rate sensitive assets including off-balance sheet position.

An asset or liability is normally classified as rate sensitive if:



If there is a cash flow within the time interval.



The interest rate resets or reprocess contractually during the interval.



RBI changes the interest rates i.e., on saving deposits, export credit, refinance, CRR balances and so on, in case where interest rate are administered.



It is contractually pre-payable or withdraw able before the stated maturities

The Gap is the difference between Rate Sensitive Assets (RSA) and Rate sensitive Liabilities (RSA) for each time bucket.

The positive GAP indicates that RSAs are more than RSLs (RSA>RSL).

The negative GAP indicates that RSAs are more than RSALs (RSA