Components of Assets and Liabilities in Bank’s Balance Sheet and their Management: CAIIB Paper 2 (Module D), Unit 1

Components of Assets and Liabilities in Bank’s Balance Sheet and their Management: CAIIB Paper 2 (Module D), Unit 1

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We all know that CAIIB exams are conducted by the Indian Institute of Banking and Finance (IIBF).  CAIIB is said to be one of the difficult courses to be cleared for the bankers. But we assure you that with the help of our “CAIIB study material”, you will definitely clear the CAIIB exam.
CAIIB exams are conducted twice in a year. Candidates should have completed JAIIB before appearing for CAIIB Exam. Here, we will provide detailed notes of every unit of the CAIIB Exam on the latest pattern of IIBF.
So, here we are providing “Unit 1: Components of Assets and Liabilities in Bank’s Balance Sheet and their Management” of “Module D: Balance Sheet Management” from “Paper 2: Bank Financial Management (BFM)”

About

It has always been the function or responsibility of Treasury and other financial strategic departments. However, of late Asset Liability Management departments are being established and asset and liability committees are being formed within financial institutions. These committees are often given extraordinary powers regarding the mix and match of assets and liabilities and have large influence in winding up activities which do not fit business strategy.

Components Of A Bank’s Balance Sheet

Like any balance sheet of any other firm, a bank’s balance sheet also comprises of sources and uses of funds. Liabilities and net worth form the sources of the bank’s funds, whereas assets represent uses of funds to generate revenue for the bank.

The summarised form and its components are:

Sources of Funds Application of Funds
Capital

Reserves

Deposits

Borrowings

Other Liabilities and provisions

 

TOTAL

Cash In Hand and Balance with RBI

Balances with Banks and Money at Call and Short Notice

Investments

Advance

Fixed Assets

Other Assets

TOTAL

 

Components of Liabilities

Capital

  • Capital represents the owners’ stake in a bank and it serves as a cushion for depositors and creditors to fall back in case of losses. It is considered to be a long-term source of funds. Minimum capital requirement for the domestic and foreign banks is prescribed by Reserve Bank of India.

Reserve and Surplus

The components under this item include statutory reserves, capital reserves, share premium, revenue and other reserves and balance in profit and loss account.

Deposits: The main source of funds for the banks is deposits. The deposits are broadly classified as deposits payable on demand which include current deposits , overdue deposits , call deposits, etc. Second category is savings bank deposits and lastly the term deposits which are repayable after a specified period, known as fixed deposits, short deposits and recurring deposits.

Borrowings: Borrowings in India consist of borrowings/refinance obtained from the RBI, other commercial banks and other institutions and agencies like IDBI, EXIM Bank of India, NABARD, etc.

Other Liabilities and Provisions: The other liabilities of the bank are grouped into the following categories:

  • Bills Payable: This includes drafts, telegraphic transfers, travellers cheques, mail transfers payable, payslips, bankers’ cheques and other miscellaneous items.
  • Inter-Office Adjustments: The credit balance of the net inter-office adjustments.
  • Interest Accrued: The interest accrued but not due on deposits and borrowings.
  • Others: All other liability items like provision for income tax, tax deducted at source, interest tax, provisions, etc.

Components of Assets

Cash and Balances with RBI

All cash assets of banks are listed under this account and it forms the most liquid account held by any bank. The cash assets consist of the following:

  • Cash in Hand: This asset item includes cash in hand, including foreign currency notes and cash balances in the overseas branches of the bank.
  • Balances With RBI: Cash account also includes the balances held by each hank with RBI in order to meet statutory cash reserve requirements (CRR) and also surplus cash parked with RBI over and above CRR requirement to meet emergency funding requirements.
  • Balances with Banks and Money at Call and Short Notice: The bank balances include the amount held by the bank in the current accounts and term deposit accounts with other banks. Under call money market, funds are transacted on an overnight basis and under notice money market, funds are transacted for a period between 2 days and 14 days.

Investments

  • A major asset item in the balance sheet of a bank is investments in various kinds of securities. These include investments in government securities, approved securities, shares, debentures and bonds, and/or joint subsidiaries ventures and other investments.

Advances

The most important asset item on a bank’s balance sheet is advances. These advances which represent the credit extended by a bank to its customers, forms a major part of the assets for all the banks.

  • Cash credits Overdrafts and Loans Repayable on Demand. Items under this category represent advances – which are repayable on demand though they may have a specific due date.
  • Term Loans. All term loans extended by a bank are included here. These advances also have a specific due date, but they will not become payable on demand. In short, most of the term loans are repaid in the form of EMIs (Equated Monthly Instalments).
  • Bills Purchased and Discounted. This item includes the bills discounted purchased by banks from the client irrespective of whether they are clean/documentary or domestic/foreign.
  • Secured/unsecured Advances. Based on the underlying security, advances are classified into the following categories:
  • Secured by Tangible Assets: All advances or part of advances, within/outside India, which are secured by tangible assets will be considered as secured assets.
  • Covered by Bank/Government Guarantees: Advances in India and outside India to the extent they are covered by guarantees of Indian and foreign governments/banks and DICGC and ECGC will be included here.
  • Unsecured Advances: All advances that do not have any security and which do not appear in the above two categories will come under this category.

Fixed Assets: All fixed assets of a bank, e.g., immovable properties, premises, furniture and fixtures, hardware, motor vehicles are classified into fixed assets.

Other Assets: The remainder of the items on the asset side of a bank’s balance sheet are categorised as other assets. The miscellaneous assets that appear are:

  • Inter-office Adjustments: Debit balance of the net position or the interoffice accounts, domestic as well as overseas.
  • Interest Accrued: This will be the interest accrued, but not due on investments and advances and interest due, but not collected on investments.
  • Tax Paid in Advance/tax Deducted at Source: This includes amount of tax deducted at source on securities and the advance tax paid to the extent that they are not set-off against relative tax provisions.
  • Stationery and Stamps: Stock of stationery on hand is considered under this head of account.
  • Non-Banking Assets Acquired in Satisfaction of Claims. Items under this account include immovable properties/ tangible assets which are acquired by a bank in satisfaction of the bank’s claims on others.
  • Others: Other items primarily include claims that are in the form of clearing items, unadjusted debit balances representing additions to assets and deductions from liabilities and advances provided to the employees of a bank.

Contingent Liabilities

A bank’s obligations under issuance of letter of credit, guarantees and acceptances on behalf of constituents and bills accepted by the bank on behalf of its customers are reflected under contingent liabilities. Other contingent liabilities include claims against the bank not acknowledged as debts, liability for partly paid-up investments, liability on account of outstanding forward exchange contracts and other items like arrears of cumulative dividends, bills rediscounted, underwriting, commitments, estimated amount of contracts remaining to be executed on capital account and not provided for, etc.

Bank’s Profit and Loss Account

A bank’s profit and loss account has following components:

  • Income: which includes Interest income and other income.
  • Expenses: which includes Interest expended, Operating expenses and Provisions and Contingencies:

Income

Interest income

  • Interest/ Discount on Advances/ Bills
  • Income on investments
  • Interest on Balances with RBI and Other Interbank Funds

Other income

  • Commission, Exchange and Brokerage
  • Profit on sale or investment
  • Profit on Revaluation of investment
  • Profit on sale of land, Building and other Assets
  • Profit on Exchange Transactions
  • Misc income

Expenses

  • Interest on Deposits
  • Interest on RBI/Interbank Borrowings
  • Others

Operating Expenses

  • Payments to and Provisions for Employees
  • Rent, Taxes and Lighting
  • Printing and Stationery
  • Advertisement and Publicity
  • Depreciation on Bank’s Property
  • Director’s fees, Allowances and Expenses
  • Law-charges
  • Postage
  • Repairs and Maintenance
  • Insurance

What Is Asset Liability Management?

Because the business of banking involves the identifying, measuring, accepting and managing the risk, the heart of bank financial management is risk management. One of the most important risk-management functions in banking is Asset Liability Management (ALM).

Asset Liability Management is concerned with strategic balance sheet management involving risks caused by changes in interest rates, exchange rate, credit risk and the liquidity position of a bank. With profit becoming a key-factor, it has now become imperative for a bank to move away from partial asset management (Credit and Non Performing Asset) and partial liability management, towards an integrated balance sheet management where all the components of balance sheet and its different maturity mix will be looked at from the profit angle of the bank.

Asset Liability Management (ALM) is the act of planning, acquiring, and directing the flow of funds through an organisation. The ultimate objective of this process is to generate adequate/stable earnings and to steadily build an organisation’s equity over time, while taking reasonable and measured business risks.

Significance Of Asset Liability Management

Some of the reasons for growing significance of Asset Liability Management are:

  • Volatility: Deregulation of financial system changed the dynamics of financial markets. The vagaries of such free economic environment are reflected in interest rate structures, money supply and the overall credit position of the market, the exchange rates and price levels.
  • Product Innovation: The second reason for growing importance of ALM is the rapid innovations taking place in the financial products of the bank. While there were some innovations that came as passing fads, others have received tremendous response. In several cases, the same product has been repeated with certain differences and offered by various banks (normally called as old wine in new bottle). Whatever may be features of the products, most of them have an impact on the risk profile of the bank thereby enhancing the need for ALM. For example, Flexi-deposit facility.
  • Regulatory Environment: At the international level, Bank for International Settlements (BIS) provides a framework for banks to tackle the market risks that may arise due to rate fluctuations and excessive credit risk. Central Banks in various countries (including Reserve Bank of India) have issued frameworks and guidelines for banks to develop Asset Liability Management policies.
  • Management Recognition: All the above-mentioned aspects forced bank managements to give a serious thought to effective management of assets and liabilities. The managements have realised that it is just not sufficient to have a very good franchise for credit disbursement, nor is it enough to have just a very good retail deposit base. In addition to these, a bank should be in a position to relate and link the asset side with the liability side. And this calls for efficient asset-liability management.

There is an increasing awareness in the top management that banking is now a different game altogether since all risks of the game have changed.

Purpose and Objectives Of Asset Liability Management

An effective Asset Liability Management technique aims to manage the volume, mix, maturity, rate sensitivity, quality and liquidity of assets and liabilities as a whole so as to attain a predetermined acceptable risk/reward ratio. Thus, the purpose of Asset Liability Management is to enhance the asset quality; quantify the risks associated with the assets and liabilities and further manage them. Such a process will involve the following steps:

  • Reviewing the interest rate structure and comparing the same to the interest/product pricing of both liquidity assets and liabilities.
  • Examining the loan and investment portfolios in the light of the foreign exchange risk and liquidity risk that might arise.
  • Examining the credit risk and contingency risk that may originate either due to rate fluctuations or otherwise and assess the quality of assets.
  • Reviewing the actual performance against the projections made and analysing the reasons for any effect on the spreads.

The Asset Liability Management techniques so designed to manage various risks, primarily aim to stabilise the short-term profits, long-term earnings and long-term substance/quality of the bank. The parameters that are selected for the purpose of stabilising Asset Liability Management of banks are:

  • Net Interest Income (NII)
  • Net Interest Margin (NIM)
  • Economic Equity Ratio

A brief description of these parameters is given below:

Net Interest Income (NII)

The impact of volatility on the short-term profit is measured by Net Interest Income.

Net Interest Income = Interest Income – Interest Expenses.

In order to stabilise short-term profits; banks have to minimise fluctuations in the NII.

Net Interest Margin (NIM)

Net Interest Margin is defined as net interest income divided by average total assets.

Net Interest Margin (NIM) = Net Interest Income/Average total Assets.

Net Interest Margin can be viewed as the ‘Spread’ on earning assets.

The net income of banks comes mostly from the spreads maintained between total interest income and total interest expense. The higher the spread, the more will be the NIM. There exists a direct correlation between risks and return. As a result, greater spreads only imply enhanced risk exposure. But since any business is conducted with the objective of making profits and achieving higher profitability is the target, it is the management of risks and not risk elimination, that holds the key to success.

Economic Equity Ratio

The ratio of the shareholders’ funds to the total assets measures the shifts in the ratio of owned funds to total funds. This fact assesses the sustenance capacity of the bank.

Objectives of ALM

At macro-level, Asset Liability Management leads to the formulation of critical business policies, efficient allocation of capital and designing of products with appropriate pricing strategies. And at micro-level the objectives of Asset Liability Management are two folds. It aims at profitability through price matching while ensuring liquidity by means of maturity matching.

  • Price Matching basically aims to maintain spreads by ensuring that the deployment of liabilities will be at a rate higher than the costs. This exercise would indicate whether the institution is in a position to benefit from rising interest rates by having a positive gap (assets > liabilities) or whether it is in a position to benefit from declining interest rates by a negative gap (liabilities > assets).
  • Liquidity is ensured by grouping the assets/liabilities based on their maturing profiles. The gap is then assessed to identify future financing requirements. However, there are often maturity mismatches, which may to a certain extent affect the expected results.

ALM as Co-Ordinated Balance Sheet Management

The asset liability management function can be viewed in terms of two-stage approach to balance sheet financial management as follows:

Stage 1

Specific Balance Sheet Management Functions

Asset side Management will include:

  • Reserve position management
  • Liquidity management
  • Investment/Security Management
  • Loan Management
  • Fixed-Assets Management

Liability side Management will include:

  • Liability Management
  • Reserve Position Management
  • Long-Term Management (Notes and Debentures)
  • Capital Management

Stage 2

Income-Expense Functions

Profit = Interest Income – Interest expense – provision for loan loss+ non-interest revenue – non-interest expense – taxes

Banks are required to formulate policies to achieve following objectives of Asset Liability Management:

  • Spread Management
  • Loan Quality
  • Generating fee income and service charges
  • Control of non-interest operating expenses
  • Tax Management
  • Capital Adequacy

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