This document discusses asset liability management (ALM) strategies in banks, particularly in India and China. It summarizes various academic literature on ALM strategies and their impact. ALM involves managing the maturity mismatch between a bank's assets and liabilities to minimize risks from interest rate changes. While ALM is crucial for banks, debt markets in India are less liquid than in other countries, constraining banks' ability to trade debt and implement optimal ALM strategies. The document argues for developing more liquid debt markets in India to help banks better manage risks from maturity transformation.

1. The primacy of Asset Liability Management
Strategy in banks and its impact in quasi -
reformed banking structures
Setting the path for a renewed industry to tread responsibly and face up to growth
Amit Mittal
Pursuinga Ph.D. inFinance
FPM15003
Submitted to Prof Prakash Singh
Keywords: AssetLiabilityManagement,MaturityTransformation,EmergingMarkets,India,China,Asia,
Commercial Banking, Treasury Management
INDIAN INSTITUTE OF MANAGEMENT
LUCKNOW

2. Contemporary Research in Banking and Risk AmitMittal,FINANCE,FPM15003
Management
2
The primacy of
Asset Liability
Management
Strategy in banks
and its impact in
quasi-reformed
banking
structures
Setting the path for a renewed industry to
tread responsibly and face up to growth
Abstract: After a debilitating crisis, returning to
the job at hand inabsence of wholesale banking
markets in the domestic industry, makes banks’
tasksunique andtime consuminginIndia.Banks
in India have shown the advantages of being
partners in the policy making and Economic
development process. They have been
recognized as leading the institutional
juggernaut across the world at the forefront of
profitability scores till before the crisis but
increasingly face up to larger NPAs and
decimated opportunities for Direct lending,
which can be a bane without lack of specialized
secondarymarkets.PrimaryTreasuryOperations
cannot substitute for Risk Management in
lending though there are advantages to a
conservative banking structure still lending 75%
of its assetportfoliotransformingdepositsfrom
retail branch networks
Keywords: Asset Liability Management,
Maturity Transformation, Emerging Markets,
India, China, Asia, Commercial Banking,
Treasury Management, Technology
Introduction
Traditional asset liability management accounts
for a majority of the bank’s wealth especially
when supplemented by modern Financial
technologythathasgloballyledtointense useof
interest rate swaps and other derivatives or
financial innovations to bridge the durationgap
carried between assets and liabilities in
incomplete and complete hedges and / or
speculation by the Bank’s Treasury to accrue
additional profits to that earned by Net Interest
Income from assets and Fee Income from Retail
consumers, Corporates and or Investment
Banking and Transaction Banking clients.
However, while Banks in India increasingly
rampedupthe use of swapsinthe lastdecade or
two foritself andfor itslendingclients,theystill
rely on the structured traditional asset liability
management to support business which in
operational terms accounts for deposits and
corresponding lending with limitedrecourse to
wholesale lending markets, directly interceding
in the inter-bank markets for requirements
including that of statutory reserves.
Governments have to step in directly to fund
banks’ balance sheets to make up for any gap
causedby inopportune lendingandotherforced
NPAs recently brought round to higher levels
through a twin move in completing
systemization and a contraction of demand in
lendingmarketsasrecoverytakesitstime toset
in.
Investigating ALM strategies: A Review of
the Literature
DeYoung et al (2008) comment on the
characteristics of ALM strategies in the context
of the other large universal banking system of
the US whichalongwithChinaisfrequentlycited

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in popular literature. The US system shows up a
distinct breach in the national banking industry
structure in the pre-crisis days enabling a new
classification of banks with weaker ALM and
strongeronriskmitigationstrategies.Eveninthe
US large banks remain strongly affiliated with
traditional ALMunderlining the criticality of the
strategy for banks. In effect the paper manages
to convey the primacy of ALM in Bank
management,forcingsmallerbankstoadoptthe
universal practice to lend stability to their
balance sheets.
In contrast to India, US banking markets and in
fact all US funding markets heavily rely on the
skewed strategy of funding longer term assets
with shorter liabilities as the ‘normal’ upward
rising yield curve turns it more profitable.
Needlesstosay,thestrategyishigheroninterest
rate riskand infactthe authorsgo onto blame it
inpartforthe 2008 crisis.The strategyisenticing
forsmallerbanksinthe thriftssectorthatrelyon
higher cost deposits and yet are a constant
burden on the exchequer with instant bailouts
after a real estate crash.
In its simplest form the ALM strategy is a
durationbasedimmunizationstrategy,liabilities
required to match assets’ duration to immunize
the portfolio from interest rate movements.
DeYoung uses canonical correlation analysis to
measure the matching of assets with liabilities
and equity whence its essential non directional
force accommodates banks with a primary
Depositfranchiseandotherswithaprimaryloan
franchise. Saha, Basu et al (2009) develop the
evidence of ALM in the Indian Banking sector
with a cross section of rates in a term structure
with causal linkages to the evidenced interest
rate risk.
In earlier papers we refer Song and Thakor
(2007) thatcreatesa contrarianviewagainstthe
tenets of ALMfor the case of relationship loans
butin general explorethe loanbyloanconstruct
of a qualitative basis for piecewise ALMfor the
development of theory. Also in US banking
markets, the Central Bank discount window use
is limited to emergencies signaling weaknessin
the banks’ strategy which we attribute to the
existence of deeper debt trading markets and a
larger network of relationships with investors
and banks that are the banks’primarysource of
Capital. (Ennis and Weinberg, 2013)
Andreason and Ferman(2012) refer the
predominant use of the one period banking
model proposed by Diamond and Dybvig(1983)
as the reason why there is a lack of focus on
studiesof the impactof ALM. The papergoeson
to evidence the beneficial dampening impact of
ALMstrategyinpropagationof economicshocks
providing a lag between the consumption and
investment response of a technology shock
Recent libations and their counter response
from regulators have also added a liquidityand
additional tangible equityleveragelimitationson
banks’ balance sheets. Jean Dermine (2015)
relates the same to the ordinary maturity
mismatch model of the bank which makes it
subject to bank runs (ibid.) Both Andreason
(2013) and Dermine (2015) point to the
requirementof fundingwithshorttermdeposits
as a response to the assumedliquidityriskfrom
depositsbeingwithdrawable ondemandandthe
provision of liquidity thus being a challenge to
the Treasury’s immunization strategy.
Agca et al (2015) raise the concern relevant to
ALM in their contrast of Advanced Economies
and Emerging Markets that openness to Global
funding markets has led to shorter debt
maturitiesinthe emergingMarkets inthestudy.
Private Banks from India as well as PSBs now
frequently access International markets, for
small tranches of capital infusion.
Entrop et al(2014) summarize the problem of
ALM thus: a reinvestment opportunity risk from
rollingcontractsata disadvantageousrate when
the term structure moves against you and a

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valuationriskfromthe changedvaluationof the
assets as well as liabilities tackled in Saha, Basu
et al. (2009) IFRS regulations from 2016 (fully
turnedin 2019) require markingtomarket of all
assets and liabilities in financial statements.
Banks,howeverdonotmarksuchinvestmentsin
the HTM category to market values and carry
them at cost. Brunnermeier et al(2013)
additionally specify the continuing inability of
banks to handle liquidity shocks resulting from
the skewed build-up of depositsand assets. We
are convincedthe shorttermopportunismof the
strategy has been shown up by the overuse of
the same bybankswell exceedingthesizewhere
they were disadvantaged to employ an end to
end ALMstrategy.
The Brunnermeier et al (2013) model in
particular shows the reliance on creditors
instead of depositors to finance relationship
loans may offer a flawed dynamic that ends in
tears. This model (ibid) in particular provides a
clear picture as well on the disadvantage to
syndicate lenders in the case of traditional
models run in India without the mitigating
feature of secondarymarketsindebtandthusto
an extent over reliance on ALMstrategy
Leveraged borrowing on the other hand
acceleratesboombustcyclesin the economyas
a whole andtraditional ALMstrategiescaneasily
limit the exposure to such borrowings on the
bank balance sheet even if secondary debt
trading was to take off in the country providing
the flexibility of using other capital to finance
loans while fulfilling statutory bank capital and
liquidity requirements.
Allen, Carletti et al(2014) develop a model of
liquidity provision by the interbank markets
depending on trading of not just interbank
liquidity but secondary sale of debt assets. The
model of course goes on to rigorously treat the
mitigation of illiquidity by well advised central
bank intervention. However, one can intuitively
ascribe a bigger challenge to this liquidity
provision in markets with only trading in pure
liquidity such as in India
A Macroeconomic Bounty for India and
China
China has been much in the news as a new big
brother for the world at large, spreading its
global trade and investments during the
intervening crisis in line to grow to the highest
levelsof GDPgloballyevenasUSstallsupduring
2014 and 2015 ahead of the return of real
interest rates. Yet, China’s banks face an uphill
task lining up to a coming credit crunch before
growth proceeds again.
India is also facing some challenges in reviving
growth and investment but though it relies on
banksfor policybasedgrowth leadership,banks
are professionallyrun entities facing a stigma in
consistent government largesse while facing up
to the challenge of fresh lending while making
adjustmentsforgrowingNPLsexpectedtopeter
out in 2016.
Both banking models remain tuned to ALM
based banking leadership maintaining a
relationship between deposits and credit, while
India’s policy denizens never seem to have a
problem of China’s size in Balance sheet holes
caused by inopportune NBFC and real estate
lending.
Further research based on cross sectional
analysis of macroeconomic factors is likely to
show thus a more sustainable trajectory and
lesser required policy intervention in Indian
banks. In the current scenario, the most visible
gap between India and China in terms of
otherwise equable growth is the lack of scaling
up of credit in India because of the lack of
investorinterestinprotecteddebtmarketsthat
constrain Indian debt to be traded and reduce
the available growth in the real economy.
Though that problem is not essentially that of
the banking sector, Bank ALM proceeds to give
usa viable safetywallinallowingmore tradingin

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debtand enablingamore efficientdebtmarkets
mechanism
Trading in Indian Debt
Indian CDS trade at near the sovereign CDS
marks for the regularly traded name debts like
SBI and Reliance at near 160 bps which could
trade in more liquid markets and reduce the
reliance of banks and other issuers on the short
termdebtmarketsfromQIPinvestors.Asstudies
by Rao(2007) and others show, Indian Bank
profitability is best in class and NPL ratios are
unlikelytobe as worrisome asin China or other
comparable markets in Asia and Europe. The
debt segment on the NSE shows the average
ticketsize hasincreasedtoRs42.31 croresinthe
currentyearto date withvolumesof Rs8Trillion
in each of the last 3 years
That still means only 80 trades take place each
day while the interest term structure is still as
dynamicas inthe liquiddebtmarketsof US and
Europe.
In our specificcontext,thislackof depthin debt
tradingis likelytobe particularlychallengingfor
Bank Treasuries and shadow banking financial
institutions thattrade fordebtmutual fundsand
Project Finance investment vehicles. Pricing for
sanctioned and private OTC debt deals that still
take place by phone as much as on Terminals is
definitely a weakness of these markets as most
of the literature on the subject and from the
crisispointstothe wantonnegotiatingpowersof
the traders in an OTC deal armed with
management sensitive information on the
counterparty making bank treasuries
characteristically more defensive playersin the
market. Government treasuries make a large
proportionof thesetradesandbankscontinueto
hold larger than required high SLR and CRR
requirements of 25.5% as of date.
There is no stigma or sloth associated with
holdingmore of liquidgovernmentsecuritiesyet
some of thisexcessinventoryisareactiontothe
illiquidity of traded debt in the markets. Bank
sources suggest even for upbeat retail tranches
not more than a dozen securitization deals of
prime debt are conducted across private and
foreign banks and the presence of PSBs is
marked by just one or two players.
Institutional investors like LIC have virtually no
tradingindebtwhilebeingontapforPublicIPOs
and running concentration risk in equities, a
situation of significant connotations when
considering the difference in ticket sizes.
Foreign banks and ALM, and the inverted
yield curve
Claessens and Horens(2012) present an IMF
analysis of foreign banks the data wherein
confirms India’s situation to be aberrant to the
larger instability ascribed by foreign banks in
AEs (20% share of market) and Emerging
Markets (50% share of market) However , this
also means that foreign banks are choosing to
discard the extra regulatory burden and leave
the shores of India with just a 7% share of
business after peaking in the double digits .
The datasetcoversbankownershiptill 2009 and
the analysis covers a balanced analysis of the
limitations of foreign players including the post
crisis withdrawals from these markets
However even prior to this withdrawal post
crisis, foreign banks have notably been
significantunderperformersinlendingandcarry
much weaker Lending Deposit Ratios
(alternativelyCreditDepositRatios) especiallyin
India and OECD countries.
This confirms that the current trend by
regulators to demand commitments from
ForeignBanksisawell thoughtoutone andIndia
should continue to assesseach such application
carefully. This section corrects any bias
purportedto be inour analysisof the tea leaves
in laying the ground for good research. AE
modelsof macroeconomicdeterminantsof term

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structure are also unlikely to be any secular
determinants of the determinants of term
premia or the requirements of a continuing
inverted yield curve with more uncertainty
perceivedinlongermaturitydebtbecauseof the
commitments as shorter term rates could
continue to be determined by temporary
liquidity conditions.
Brick (2012) and Birge and Judice(2013)
technically present the definition and current
symptoms and targets for an optimal bank ALM
strategy. ALM strategies depend on both static
and dynamicsimulations,includingaSims(1980)
advocated VAR simulation (VECM/Vector Auto
regression) and modeling interest rates nd the
consequent correlated impact on both dies of
the balance sheet. We recommend
Novickyte(2013) for the references in the
extensive literature review.
Retail deposit rates continue to be a cheap
funding source in India, unlike the rigidity
evinced by near zero rates and the consequent
high relative cost of deposits denting bank
profitability measures in the US. Markowitz led
ALM models are out of scope of our analysis as
they represent work specific to Insurance
interestsandhave a limitedapplicabilityinBank
balance sheets without perpetuities and no
significant exposure to stocks, though basic
stochastic models with some Markowitz like
characteristics are applicable. Simulation
methods and both stochastic and deterministic
implementations use linear and goal
programming to solve the ALM management
problem for banks.
Short term rate moves hurt on the increasing
side if liabilities have to be refinancedwhile the
literature suggests that consistent asset growth
during booms is likely to result in an increase in
non-core liabilities (riskier liabilities to finance
the boom) thoughtdespiteasustain13%lending
growth across the last decade in India with a
near20% lendingassetgrowthinleadingPrivate
sectortradedandeffectivePSBshasnotresulted
in such a capitalization conundrum for Indian
banks.
A review of quantitative ALM techniques
in the literature
Vector Auto Regression model in Birge and
Judice
The bank has following assets and liabilities
Equity E, Loans L with Interest Income I and N
alludestoNon-corefundingintheoriginal model
but we use it for all other liabilities in the
absence of traded debt markets and in the
likelihood of Inter-bank markets and STF from
external QIPs making the difference
In the Indianscenario,Depositsgrow at15% ina
creditenvironmentgrowingata17-18% rate and
the requirement of additional funds from Non
core deposits is probably not critical even after
changes in the market structure
Taking a power utility and maximizing Expected
utilityina first orderTaylor seriesexpansionfor
new Loans L* for new offtake n( includingretail
and home loans as well as business lending)
L*=E.E(n)/αE(n^2)-L.E(n(old)*n)/E(n^2)
The model can also be simply extended in
determinate terms of L(t+1) and L(t) in the
balance sheet measures to track the move in
ALM assets and Liabilities with or without
stochastic dependencies
Howevera simpleranalysisisperse essential to
take into account the macro trading
manifestations of the ALM correction
mechanisms which are the first recourse. The
AssetLiabilityManagementstrategychosenisa
functionof the periodof eachcorrectionandthe
change in market value of the assets and
liabilities independently and together to the
same change in interest rates measured by
duration measures including Dollar Duration
more commonlyreferredtoasthe PVBPandthe

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similarsensitivityof Income(NetInterestIncome
) from that change in interest rates.The change
in liquidityassetsof the bankfroma measure of
the DollarDurationwill give a directmeasure of
the Liquidity gap and will account for the
Liquidity Risk.
The Integrated ALM perspective
Gulpinar and Pachamova(2013) also recognize
the importance of optimizationbutagaininclude
the business of pension funds and insurance
companies and again focus on the problem of
extending ALM over infinite no. of periods as
possible computationallyusingacombinationof
stochastic and dynamic programming
techniques. In our opinion such a
computationally intensive simulation and
optimization solution will require a few months
of being operationally implemented as ALM to
garner effectiveness from the data and
experience thence available and the problem is
not as dynamic with effective duration based
techniques able to tractably manage interest
rate, liquidity and profitability risks on a bank
balance sheet with a longer or medium term
Treasury strategy by savvy traders and
accountants. One needs to effectively monitor
time varyingaspectsof assetreturnsandinterest
rates with the measure of the surplus
determined by the excess of liabilities over
assets.
Marketscontribute tothe ALMproblembybeing
concerned with the economic expansions and
recessions that translate to Bullish and Bearish
markets and thus Markowitz portfolio models
can be applied to the portfolio of assets and
liabilities including popular regime switching
models that identify expansion and recession
modes and equally subject to strategic
imperativesandmayincludetothatextentgame
theoretic solutions of incomplete information
and solutions remain Markovian with a
memoryless property
Continuous time Markowitz Mean Variance
implementations have been accepted as a
System of Stochastic Differential Equations with
the martingale property implementation with
GeometricBrownianMotionprocessesforasset
returns, first attributed to Lieppold (2004)
Sharpe and Tint(1990) applied MV optimization
in the static setting to the ALMproblem at first.
The recent coverage of economics and markets
linkages has confirmed that upturns follow or
lead bullish periods and downturns follow or
lead bearish periods. All Markov models
including traditional Mean Variance
Optimizationportfolioscanthusbe modifiedfor
a different ALM for bullish periods and bearish
periodsThisfollowstheworkofHardy(2001) and
Henderson and Quandt(1958) showing the
superiority of regime switching models in
Maximum likelihood maximization. Chen and
Yang(2014) applythe Asset –Liabilities=Surplus
Management model with uncontrollable
liabilities;assumingn+1 securitiesandaMarkov
Chain. However Hardy and ibid follow an
extended framework including insurance
companiesandthusincludeequitiesasassetsfor
the ALMprocedure
Rutkauskas(2006) consider the problem of
liquidityandperfectALMfora commercial bank.
and we recommend their literature review for
this section
Building on the first Linear programming and
Goal programming models, most notably the
ChamberandCharnes(1961) model,theirreview
sees the coming together of extended
simulations including Grubman(1987) and then
on to stochastic modeling using the above
Markowitz frameworks by Pyle (1971) which
howeverdoesnotbalance assets and liabilities
Brodt(1978) createda MV model that optimized
profits and the third approach used in banking
literature includes chance constrained models

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by Charnes et al (1968) and Pogue(1972) with a
12 period chance constrained model
The fourthapproachhighlightedinRutkauskasis
a decisiontheoreticapproachproposedbyWolf
(1969) The Bradley and Crane (1972) model is
based on the same. Eppen and Fama (1971)
concretized a fifth dynamic programming
approach whence the literature returns to
stochastic linear programming including the
Russell YasudaKasai model by Crane etal(1994)
Thus an amalgamated approach is used in ibid.
involvingmultipleobjectivesportfolioefficiency,
feasible risk and guarantee and utility
frameworks to meet objectives of liquidity,
solvency and average yield of assets and
liabilities solved with goal programming (the
Integrated ALM perspective)
Sovereign Debt portfolios
Before we move on to our main propositions
basedon the environmentandthe literature on
ALM, we must additionally include focus on
Central Bank ALM. One such research that
focuses on Sovereign debt portfolios is
Papaioannou(2011) basedonthe IMF’sobserved
denoument of the crises from unbalanced debt
portfolios , outlining normal recourse such as
debt swaps and buybacks available to a
sovereignand/oraCentral Bankinmanagingthe
unbalanced debt positions and the liquidity
concerns of nations
Innon-crisisconditions,Liabilitymanagementby
itself focusses on financial operations to
maximize the utility of the debt profile with
better terms on existing debt and a sustainable
medium debt maturity profile. In crises
conditions this desk additionally handles debt
restructurings to provide an adequately finance
debt program with at least medium term
viability
Thus debt managers are involved even at the
sovereignlevel inmanaging: (1) marketriskfrom
interest rates movements and exchange rate
volatility (2) refinancing risk near maturity (3)
liquidity risk including the availability of
sufficient demand for the debt to avoid price
distortion (4) credit risk as determined by its
creditratingand /orthe sovereign’sabilityto or
willingness to fulfil its obligations, its Credit
Default Spreads and the Contingent Claims
approach and 95) operational risk covering
financial markets and their technology and
settlement procedures
Risk measures remain the same in terms of
symmetrical and quantile measures like
Variance,S.D.and VaR quantilesfromabroader
class of Lower Partial Moments gleaned by the
author from risk literature
Sovereign liability management underlines the
need to identify ALMas an art and it cannot be
defined as a nuts and bolts or well-structured
policy area. Sovereign debt managers much like
bank debt managers rely on extensive
networkinganddebtswappingduringfavorable
market conditions and /or anticipated breaches
of risk thresholds
As a sovereign debt manager one I s also
concerned with a calendared and predictable
national financing program with transparent
auction programs and authorized dealers
Markets also expect defined policies of debt
swaps and buybacks. While paying down debt
care must be taken when shorter maturity debt
is swapped out for longer maturity to be
balanced with buybacks of longer term debt as
well (ibid)
Current business challenges for
Commercial Banks and the
pressures on ALM
Basedon the above literature review,one might
note the forced casualty in managing ALM
operations, emanating initially from its broader

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impact on the confidence in the banks’
operations and that of entire nations, but
divergent schools of thinking evenin developed
markets and a sometimes myopic non
recognition of the concurrent impact of active
ALM on Credit & Operational risk , liquidity,
profitabilityaswell asmitigationof interestrate
and exchange rate risks on the banks’ balance
sheets. The critical role of treasury in banks
operations between the Corporate Lendingand
Retail banking businesses, between liquidity
provision services of the bank including
Transaction Banking and the non-fund based
advisory services that standalone may not
immediatelybe available tomitigate the impact
of asynchronous ALM, assert and impact
manifestationof anyshortmediumorlongterm
bank strategy.
Ensuring the deployment of Statutory Bank
reservesmaybe one startingpointfor the need
for ALMto manifestitself atthe bank.However,
it seems more germaine to consider all the
movingpartsanddrawupanintegratedstrategy
for ALM in the bank especially in the current
environment. In terms of techniques there are
advantages of balancing your exposure on a
duration based matching with multiple
objectives of liquidity, profitability and
sensitivity to both credit and operational risks
While systemization has been indelibly
introduced the lack of credit monitoring or
restructuring systems continues to plague
lending margins.
The issue of bank profitabilityisfurtherclouded
by a global rising rate environment in the latter
part of thisdecade interspersedbyCentral bank
injected swathes of sub normal interest rates
andliquiditydrivenflowstoIndiaandotherparts
of Asia, LatAm,East Europe andAfrica.The issue
of Non-performingloansislikelytocome backto
us once this cycle is completed in 2016. Apart
from longer term pressures on recapitalization
from public and private Financial markets this
means more immediate active concerns for the
integratedobjectivesof abank’sALM’;sprogram
especially without sacrificing larger liquidity
needsof a highgrowth environmentconcurrent
with the current positive phase of the Business
cycle
Bank interest margins have been driven down
for a decade and the prior decades largely
dormant PSB ALM strategy of leaving a surplus
position in duration between Assets and
Liabilitieshasalreadyprovedtoocostlyforbanks
as evidenced by Das and Ghosh(2007)
In the meantime significant regulatory moves
like freeing up of deposit rates hardly had any
impactonALMinthe wake of stable depositrate
environments, but the new inflation targeting
policy environment may drive India’s nominal
GDP growth and longer term credit growth
measures also down and reduce avenues for
profitable lending. There is in fact a dearth of
rated Principals approaching the banks for
lendingandthe propensityof highriskSMEloans
may make ALM a murkier practice for the Bank
Treasury teams especially with hidden
challenges to liquidity in thinly traded Indian
debt markets.
Effective maturity management at the bank
requires a sensitized interest rate forecast that
takes into account the possible variationsin the
forecast and limits on the amount at risk in
moves in the opposite direction rather than
depend on recapitalization from the
government. This maturity management takes
into account the primacy of deposit liabilities
andlendingassetsbutalsoconsidersinvestment
horizons and the risk management policies and
exposure of the bank. While the primary bank
strategymay not be initiatedbythe ALMunitor
the Treasuryfunctionitrefersto,yetthe RARCO
allocation of capital is mapped to its Treasury
and the ALM function integrates an effective
profitability strategyfor the bank only if it gives

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due weighttoriskmanagementateachfunction
and unit levels and aggregates the same
Similarly the liquidity objective will have key
constraints not in terms of regulatory capital
which may be more than usually achievable but
to manage the issuance andduration/horizonof
the new debt in lieu of the old debt being
swapped/exchanged. Again as mentioned
earlier reliance on passivity in riding the yield
curve or in pursuing the carry trade servicing
long termassets with liquidshortterm deposits
may need to be assessed continuously with
simulation and goal programming exercises and
in light of sensitivity to changes in interest rate
and exchange rate risks
Investmentmaturitystrategiesavailableevento
small and large sized banking firms include the
less intervention intensive spaced maturity
policy after the decisionon average maturity of
securities to hold in the investment portfolio
both in Available for Sale and Held to Maturity
segments These strategies may be spaced
maturity or ladder strategies, Front end loaded
maturity policy or back end loaded maturity
policy.It can be gleanedfromFinancial intuition
that the backendpolicywillbe more favorableif
ratesare expectedtofall andvice versaandthat
the investment policy itself is not immune to
even parallel shifts of the interest rate term
structure. A financial institution that goes in for
a fully optimized rate expectation approach
impliesitsreadinessandrequirementonitspart
to actively manage the strategy as he could be
caught holding short term securities in a rising
rate environment instead. The Bar bell strategy
similarily provides for liquidity at the short end
and income from the designated long term
portfolio but is susceptible to moves in the
interestrate termstructure than a n investment
portfolio of intermediate maturities
For banks holding mortgages and other retail
securities an important risk to be considered in
deciding the ALM / investment strategy is to
what extent to provide for prepayment risk of
retail assetsand exactlywhat term and value to
hold in the liquidity portfolio which will be sold
whenliquiditybecauseof depositsorbecause of
asset demand is required or because of put
options on issued debt and call options on
investments
The qualityof collateral heldagainstloan assets
and repo transactions is also critical for banks
while current regulation measures have added
limits on inter-bank exposure to the extent of
15%
Banks can now actively choose between Asset
liquidity and Borrowed liquidity management
(Liabilitymanagement) ratherthanstayfixedon
one side of the coin. Borrowed liability
management one guesses may be a costly
exercise for a bank known to be a borrower for
liquidity purposes and similarly asset liquidity
may be a critical measure of the efficacy of the
Asset Liquidity management approach for the
liquidity segment of the banking firm’s ALM
strategy. Another traditionallyrobust approach
to liquidity management that is amenable to
monitoring and quantitative and qualitative
professional execution is the structure of funds
approach which uses a trifold structure of
liabilitiesinvolatileliabilitiesthatrequire95%of
liquidityincluding reserve bank borrowings, the
proportion of the traditional deposits or
Vulnerable funds and the core deposits. While
30% may be provided for Vulnerable deposits,
traditionallyonly15percentliquidityisprovided
to core deposits. On the liquidity management
front each challenge can be monitored using
simple traditional indicators including the ratio
of Reserve bank repos and reverse repos,
Capacityfornetloansandleases(vstotal assets)
Cash and Hot money (volatile funds) ratios and
others including unutilized commitments.
We are already operating in a completely
deregulated rates environment, but challenges
on the capital convertibility front or monetary

11. Contemporary Research in Banking and Risk AmitMittal,FINANCE,FPM15003
Management
11
andfiscal stressesfromforeignexchangepolicies
and monetary and fiscal stances of neighbors
and larger trade partners like China and the US
can become significant concerns for the
economy as a whole but will be a primary front
for ALMdesksthatneedtobe sensitizedtosuch
scenarios and policy changes in light of the
exceedingly precarious position with non-
performing assets and core spreads in PSBs.
IndianPSBsare today free toproactivelychoose
an ALM stance that works for them and are
continuouslychallengedbythe competitionand
the accountability forced by public Financial
markets to actively pursue a chosen ALM
strategy with both their eyes open and proven
potential to create profits on a long term basis
for the bank.
The new pressures of evolving micro finance,
Real estate and NBFC lending as financial
services spread because of the availability of
technologybuildonthebanks’accesstolow cost
retail andotherdepositstopursue amore active
ALM strategy with avenues for liquidity and
investment across a chosen maturity profile
while meeting challenges of liquidity
Traditional marketsharesof Publicsectorbanks
are also likelyto be challenged by the presence
of efficientprivate sectorplayersequippedwith
bettertalentandpayforperformance/qualityof
life initiativesthatconvertintoamore activeand
monitored ALM and even shared access to
regulatorswithlimitedavenuestoinfluence the
state to support their profitability with instant
regulatory estoppels and continuing regulatory
delays in redressal of uneven playing fields.
Focus on infrastructure financing may further
reduce the role of banks in the guise of shadow
bankinginstitutionsandforeigncapital accessas
well asALMmeasuresrequiredtomeasure upto
25 year maturity horizon assets if they grow to
their optimum size including the example of
China’s larger state owned banks and their
experience with local governments and SOEs in
debt assets
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