Treasury and Asset- liability Management: CAIIB Paper 2 (Module C), Unit 6

Treasury and Asset- liability Management: CAIIB Paper 2 (Module C), Unit 6

Dear Bankers,
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 6: Treasury and Asset- liability Management” of “Module C: Treasury Management” from “Paper 2: Bank Financial Management (BFM)”

 Meaning Of Asset-Liability Management

The risks arise out of mismatch of assets and liabilities of the bank and asset-liability management is managing such balance sheet risks. The risks, if not controlled, may result in negative spreads or in erosion of net worth. ALM is therefore defined as protection of net worth of the bank.

Liquidity Risk and Interest Rate Risk


  • As we have seen earlier, liquidity and interest rate are two sides of the same coin, as the liquidity risk translates into interest rate risk, when the bank has to recycle the deposit funds or rollover a credit on market determined terms. However, banks are extra sensitive to liquidity risks, as they cannot afford to default or delay meeting their obligations to depositors and other lenders.
  • Even suspicion of pressure over a bank’s liquidity may prompt a run on the bank, or indeed, threaten the very survival of the bank. Hence special attention is paid to liquidity, in particular short-term liquidity (intra-day to one month) to ensure funds are promptly made available when they are needed.

 Interest Rate

Interest rate risk arises when interest earnings are not adequate to set off interest payments due in a given period, even if the book value of the asset equals that of the liability, owing to a change in market rates of interest. Net interest income (NII) of the bank is the difference between interest earnings and interest payments in a given accounting period. Hence interest rate risk may be defined as the risk of erosion of NII account of interest rate movements in the market.

Experience of ALM in Indian Scenario:

  • Depositors are always comfortable with fixed rate of interest. Bank like SBI and IDBI in the past introduced deposit schemes linked to floating rate interest, but it had not found the flavour of the depositors. Hence, these products were withdrawn.
  • Under the circumstances, in case, the deposit rate goes up subsequent to placement of deposit by the depositors, the depositor would come for premature extension of the deposit and get the enhanced interest rate. Banks also do not charge any penalty for such extension. In case, the deposit rate fall down, the deposit would continue with the deposit at the contracted rate of interest. Hence, the depositors are comfortable in fixed rate interest regime in our country and in the process effectively pass on the interest rate risk to the bank.
  • But in the advances side, RBI has introduced the MCLR system from 1s April, 2016, which is a floating rate of interest. Hence, under the interest rate falling scenario, the banks’ NIM would be come down since the deposits are at fixed rate and advances are at floating rate. In case, interest rate goes up, the banks may not actually get the full benefit of interest rate hike, as most of the depositors would come premature extension of the deposit. By this, the interest rate going up is nullified and the risk is passed on to the banks.
  • In the above scenario, it is difficult to hedge the entire interest rate risk since most of the players i.e., Banks are on one side of the market.

Role Of Treasury In ALM

As stated earlier, the core function of Treasury is fund management. It automatically engulfs liquidity and interest rate risks, as the treasury maintains the pool of bank’s funds. We may briefly explain the relationship between Treasury and ALM as under:

  • As we have illustrated above, the balance sheet of a bank carries enormous market risk (in addition to credit risk), but the banking operation itself is confined to accepting deposits, and extending credit to needy borrowers, besides miscellaneous payment services. It is Treasury which operates in financial markets directly, establishing a link between core banking functions and market operations. Hence the market risk is identified and monitored through Treasury.
  • The asset-liability mismatches cannot be ironed out as the assets or liabilities cannot be physically moved across the time bands. It may also be noted that bank earns profits out of mismatches and it is not really advisable to remove the mismatches completely from the balance sheet. Treasury uses derivatives and other means, including new product structures to bridge the liquidity and rate sensitivity gaps.
  • Treasury, while taking trading positions in forex and securities markets, is also exposed to market risk on its own creation. Sometimes the risks are compensatory in nature and help bridge the mismatches on banking side. The Treasury may therefore hedge only residual risk.
  • As the markets develop, many credit products are being substituted by treasury products. For instance, bank may subscribe to commercial purpose, instead of extending working capital to an entity. Treasury are marketable and hence liquidity can be infused in times of need. Treasury also monitors exchange rate and interest rate movements in the markets, and hence it is much easier to administer such risks through treasury operations.

Use of Derivatives In ALM

  • Derivative instruments are useful in managing the liquidity and interest rate risks, as also in structuring new products which help overcome market risk to a large extent. Derivatives replicate market movements, and hence can be used to counter the risks inherent in regular transactions. For instance, if we are buying a stock which is highly sensitive to market movements, we can sell index futures as an insurance/hedge against fall in stock prices. The advantage in derivatives is that the requirement of capital is very small, and largely there is no deployment of funds (except in case of exchange traded instruments, where there is a margin requirement – but it is only a fraction of notional amount).
  • Derivatives can be used to hedge high value individual transactions, or aggregate risks as reflected the asset-liability mismatches. In the latter case, a dynamic management of hedge is necessary as the composition of assets and liabilities is always changing. The following illustrations show how derivatives be used to manage ALM risks.

Credit Risk and Credit Derivatives

Treasury and Credit Risk

  • As we have seen, Treasury is mostly concerned with market risk. Credit risk in treasury business is only with respect to counterparty dealings, contained by exposure limits and risk management norms. In normal course, treasury operations are untouched by the credit risk present in bank’s lending business.
  • Credit derivatives (CD) help the issuer diversify the credit risk and use the capital more efficiently. The CD is a transferable instrument, though the market for CDs is not very liquid. The CD products are still emerging and various covenants related to the transaction are incorporated in the ISDA Master Agreement for Credit Derivatives.

The eligible entities under market-makers and users categories are as under:

  • Market makers: Commercial Banks, standalone Primary Dealers (PDs), Non-Banking Financial Companies (NBFCs) having sound financials and good track record in providing credit facilities and any other institution specifically permitted by the Reserve Bank. Insurance companies and Mutual Funds would be permitted if permitted by their regulators.
  • Users: Commercial Banks, PDs, NBFCs, Mutual Funds, Insurance Companies, Housing Finance Companies, Provident Funds, Listed Corporates, All India Financial Institutions namely, Export Import Bank of India (EXIM), National Bank for Agriculture and Rural Development (NABARD), National Housing Bank (NHB) and Small Industries Development Bank of India (SIDBI), Foreign Institutional Investors (FIIS) and any other institution specifically permitted by the Reserve Bank.
  • RBI has prescribed eligibility norms for market makers and has also prescribed detailed operational guidelines and capital adequacy norms for Credit Default Swaps.

Transfer Pricing

  • Transfer pricing is an integral function of asset-liability management and is in the domain of bank’s treasury. Transfer pricing refers to fixing the cost of resources and return on assets of the bank in a rational manner.
  • The treasury notionally buys and sells the deposits and loans of the bank, and the price at which the treasury buys and sells forms the basis for assessing profitability of banking activity. The treasury determines the buy/sell prices on the basis of market rates of interest, the cost of hedging market risk and the cost of maintaining reserve assets of the bank.

Policy Environment

The asset-liability management will be effective, only if there is a strong policy foundation. Though in general we describe it as ALM Policy, the policy should aim at aggregate risk of the bank and should achieve coordination between different departments of the bank and treasury. An Integrated Risk Management Policy, bearing upon Market Risk of the Bank, should ideally have the following components:

  • ALM Policy prescribes the composition of Asset Liability Management Committee (ALCO) and operational aspects of ALM, including risk measures, monitoring of risks, risk neutralization, product pricing, management information systems and more importantly how to improve and/or maintain the existing NIM, etc.
  • Liquidity Policy prescribes minimum liquidity to be maintained, funding of reserve assets, limits on exposure to money market, contingent funding, inter-bank committed credit lines etc.
  • Derivatives Policy prescribes norms for use of derivatives, capital allocation, restrictions on derivative trading, valuation norms, exposure limits etc.
  • Investment Policy prescribes the permissible investments, norms re-credit rating and listing, SLR and Non-SLR investments, private placement, trading in securities and repos, classification and valuation of investments, accounting policy etc.
  • Composite Risk Policy for Foreign Exchange and Treasury prescribes norms for merchant and trading positions, securities trading, exposure limits, limits on intra-day and overnight positions, stop-loss limits, periodical valuation of trading positions etc.
  • Transfer Pricing Policy prescribes the methodology, spreads to be retained by treasury, segregation of administrative costs and hedging costs, allocation of costs to branches/other departments of the bank etc.

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