Indian banking has undergone a paradigm shift over

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1 MANAGING GAP: A CASE STUDY APPROACH TO ASSET-LIABILITY MANAGEMENT OF BANKS Madhu Vij The importance ofmanaging the asset-liability mix in the Indian financial markets has emergedfrom the increased volatility in the domestic interest rates as well as foreign exchange rates that has evolved after liberalization. The deregulatedinterest rate environmenthas broughtpressure on the managementofbanks to maintain a good balance among spreads, profitability and long-term viability. Over the last few years, theire has been an intense competition and banks have been required to take up strategic planning as an exercise for asset-liability management in order to survive and grow in the ever increasingly competitive andrisky environment. The paperpresents a case study offour banks- Citi bank, ICICI bank, IDBI bank and SBI and studies how Asset Liability Management can be used as an important tool for managing liquidity risk and interest rate risk. INTRODUCTION Indian banking has undergone a paradigm shift over the years, and the liberalization of the economy initiated since 1991 has set in motion dramatic changes that are fundamentally reshaping the Indian banking industry. In today's globalized environment, Indian banks present a picture ofa vibrant, internationally active banking system and they appear far stronger to face the challenges that are sure to come their way in the future in the coming years. While the introduction of various financial sector reforms has resulted in substantial improvement in the financial performance ofthe banking system, it is nevertheless true that there are several areas ofconcern that affect the efficiency ofthe banking system as a whole. The issue ofnpa (non performing assets) management presents one of the biggest challenges for the banking sector. The level ofnpas continues to be high by International Standards, resulting in an adverse impact on the liquidity, profitability and competitive functioning ofbanks. Risk management is another area of concern as banks are exposed to a number ofrisks during the course oftheir business. In this context, Indian banks will also have to prepare for the effective implementation of the Basel 2 norms that become effective by March As the primary emphasis ofthe new Accord is on improving the measurement ofrisk, banks will need to prepare for changes in the regulatory framework to achieve their vision of an efficient and sound banking system. The post reform banking scenario has witnessed the entry of new private and foreign banks, interest rate deregulation, and a plethora of new products as also greater use of information technology. Banks are required to act in a more dynamic environment as they are also exposed to a whole array of risk, important among them being liquidity risk and interest rate risk. An important tool that has assumed significance for tackling the risks that the Indian banking industry is facing and which can help banks in ensuring operational viability and meeting the competitive challenge is Asset-Liability Management CALM). ALM is an integrated approach towards effective balance sheet management that can be achieved through proper restructuring of the asset and liability portfolios from time to time. In today's fast changing market environment, ALM has become important and at the same time difficult to practice. Byrne (2000) has argued that banks still find difficulty in implementing integrated asset and liability management. Asset-liability management CALM) is the art of ensuring that the maturity profiles ofassets match those

2 50. Vlj of liabilities. It combines the techniques of asset management, Iiabi Iity management and spread management into a cohesive process leading to an integrated management of the total balance sheet. The primary objective of ALM is to manage the net interest income in such a way that its level and risk are in tune with the risk-return objectives of the institution. The technique does not eliminate risk but tries to manage it in such a way that the fluctuations in ~ net interest incorne are minimized in the short-run and the longterm operating viability of the organization is taken care of. Susie Fair (2003) defines ALM as the process of evaluating balance sheet risk and making prudent decisions that enable credit unions to remain financially viable as economic conditions change. A sound ALM process integrates strategic, profitability and net worth (capital) planning with risk management, According to Patrick Totty, (2003) ALM measures balance sheet risk by predicting how earnings and other key performance benchmarks react in alternative interest-rate environments and economic conditions. ALM helps the bank in the efficient management of their assets and liabilities with a special focus on profitability, capital adequacy, liquidity and risk factors in a dynamic and competitive economic environment, Asset-liability management views the financial institution as a set of interrelationships that must be identified, coordinated and managed as an integrated system (Moynihan, Purushothaman, Mcleod, and Nichols, 2002). In order to manage effectively the various kinds of risks arising out of assets-liability mismatches, most of the major commercial banks in India have an 'Assets Liability Management Committee' (ALCO). The role of ALCO is primarily directed towards formulating a balance sheet policy for the bank based on a detailed assessment of risk-return trade off. ALCOs deliberate on maintaining liquidity in the short run and are also involved in evolving appropriate systems and procedure for the identification and analysis of balance sheet risks and laying down parameters for efficient management ofthese risks. RESEARCH DESIGN AND METHODOLOGY In order to analyze the various aspects of ALM, the maturity profi Ie offour banks has been considered. The banks analyzed are Citibank, ICICI bank, lobi bank and SBI. The position of the four banks has been analyzed with respect to liquidity risk and interest rate risk as according to Rajwade (2002) the subject ofasset liability management covers both interest rate risk and liquidity risk. The -traditional Gap analysis is considered as a suitable method to measure the Liquidity risk. Liquidity risk arises from a mismatch in the maturity of assets of liabilities and can be measured by calculating gaps over different time intervals as on a given date. Gap can be calculated as the difference between rate sensitive assets and rate sensitive liabilities. The Gap for each maturity bucket is then assessed for the liquidity risk ofthe bank. For assessing the interest rate risk, a planning horizon for forecasting the interest rate fluctuations is analyzed for different maturity buckets. The rate sensitive gap for each maturity bucket is used to assess the impact ofinterest rate fluctuations on the net interest income ofthe banks under study. The forecasting period analyzed is one year. The impact of both a falling interest rate and an increasing interest rate on the rate sensitive assets and rate sensitive Iiabi Iities as well as on the net interest income of the four banks has been analyzed. The two different scenarios analyzed are: First, interest rates decrease by 50 basis points and second, interest rates increase by 100 basis points. The data for calculating the interest rate risk and liquidity risk was obtained from Reserve Bank of India publications Report on Trend and Progress ofbanking in India and Statistical Tables relating to banks in India for various years. The RBI report gives the details ofthe maturity profile ofthe assets and liabilities ofthe banks for various years. The paper attempts a case study of four banks mentioned above and S81 bank-and examines how Asset-Liability Management can be used as an important tool for managing liquidity risk and interest rate risk. The paper has been sub-divided into four sections. Section one discusses the two important kinds of risk that banks face-liquidity risk and interest rate risk. Section two presents the GAP analysis and the net interest income. Section three analyzes the liquidity risk and interest rate risk position ofthe four banks in detail. A comparative analysis ofthe four banks has also been presented. Finally, Section four gives the concluding observations. SECTION I LIQUIDITY RISK MANAGEMENT Liquidity is a matter of cash flows as they pass through the balance sheet and income statement on a continuous basis. Liquidity risk is present when, for whatever VISION-The Journal ofbusiness Perspective Vol. 9 No.1. January-March 2005

3 reason, this flow is endangered. Ifthere is a demand for cash, particularly if it comes from outside the organization, it must be satisfied. The objective of liquidity risk management is to understand how cash flows are moving within an organization, to identify the existence and location ofcash flow strains by measuring emerging liquidity pressures, and to take corrective actions to prevent these pressures from growing (Taylor, 2001). Liquidity risk management lies at the heart of confidence in the banking system as liquidity shortfall in one institution can have significant repercussions on the entire banking system, Measuring and managing liquidity policies are key factors in the business strategy planning of banks. Liquidity risks are normally managed by a bank's asset and liabilities committee (ALCO), an approach that requires understanding of the interrelationships between liquidity risk management and interest rate management, as well as the impact that re-pricing and credit risk have on liquidity or cash flow risk and vice versa. Liquidity is necessary for banks to compensate for expected and unexpected balance sheet fluctuations and to provide funds for growth. A bank has adequate liquidity potential when it can obtain sufficient funds (either by increasing liabilities or converting assets) promptly and at a reasonable cost. Liquidity' needs are usually determined by the construction of a maturity ladder that comprises accepted cash inflows over a series of specified time periods. The difference between the inflows and outflows in each period (i.e., the excess or deficit of funds) is a starting point to rneasure a bank's future liquidity excess or shortfall at any given time, Once liquidity needs have been determined, a bank must decide how to fulfill them. Liquidity management is related to net funding requirement, and, in principle, a bank may increase its liquidity through asset management, liability management, but most frequently a combination ofboth. INTEREST RATE RISK The possibility that changes in market interest rates might adversely affect a bank's financial condition is known as interest rate risk. Management of interest rate risk is one of the critical components of market risk management in banks. Excessive interest rate risk adversely affects a bank's financial condition in the current year as also in the future. In the current year, the impact of changes in interest rates is on the net interest Managing Gap: A Case Study Approach to Asset-Liability Management ofbanks. 51 income (NIl). Changing interest rates have a long-term impact on a bank's net worth, since the economic value of a bank's assets, liabilities and off-balance sheet positions are affected by fluctuations in market interest rates. The interest rate risk, when viewed from these two perspectives, is known as 'earnings perspective' and 'economic value' perspective, respectively. ' Earnings perspective involves analyzing the impact of changes in interest rates on accrual or reported earnings in the near term. This is measured by measuring the changes in the net interest income or net interest margin (NIM), i.e., the difference between the total interest income and the total interest expense. Economic value perspective involves analyzing the impact ofchanges in interest on the expected cash flows on assets minus the expected cash flows on liabilities plus the net cash flows on off-balance sheet items. It focuses on the risk to net worth arising from all repricing mismatches and other interest rate sensitive positions. According to Randall (2000), economic value measures the potential earnings contribution ofasset and liability positions by present-valuing their cash flows at current discount rates. Properly applied, changes in economic value over time become the basis for measuring the funding center's return. Banks use a number of derivative instruments to minimize the exposure to interest rate risk, such as: interest rate swaps, futures, floors, collars and caps. This risk is considerably enhanced during a period when a decline in interest rates bottoms out and begins to move in the opposite] direction. In India, this risk is further exacerbated since it is the RBI and not the market forces that still dictate the prevailing level of interest rates. SECTION 2 GAP MODEL The most basic interest rate risk exposure measurement technique that is employed by banks and financial institutions is GAP analysis. This method requires a preparation ofare-pricing gap report that distributes rate sensitive assets, rate sensitive liabilities and off-balance' sheet positions into different time buckets according to their residual maturity or time remaining to their next repricing, whichever is earlier. The assets and liabilities that do not have contractual re-pricing intervals or maturities are assigned to maturity buckets based on statistical analysis or judgment. Interest rate risk is measured by calculating gaps over different maturity buckets. The GAP is defined as the absolute difference VISION-The Journal of Business Perspective. Vol. 9 No. I January-March 2005

4 52. Vij between Rate Sensitive Assets (RSA) and Rate Sensitive Liabilities (RSL) for each time bucket. The sign and magnitude of the GAPS in various time buckets can be used to assess potential earnings volatility arising from changes in interest rates. Positive GAP indicates that RSA are more than RSL and from an earnings perspective, the position benefits from a rise in interest rates. A negative GAP on the other hand indicates that RSL are more than RSA and from an earning perspective the position would benefit from a fall in interest rates. For a given level ofgap position, the bank can take the following positions to improve the net interest income (NIl) Maintain a positive gap when the interest rates are rising. Maintain a negative gap when the interest rates are declining. Maintain a zero gap to completely hedge against any movements in the future interest rates. Gap can be used as a measure of interest rate sensitivity by multiplying the gap for a particular time horizon by an assured change in interest rate to yield an approximate change in NIl that will occur as a result of such interest rate movements. Banks do not attempt to maintain a zero gap in all maturities as provision of liquidity is an important part oftheir function and they earn profits by providing that liquidity. The objective is to determine acceptable levels of gap. An acceptable gap depends on the banks investment strategies, the need for replacing assets and anticipated ability to repay maturing liabilities. GAP and Net Interest Income Ifthe bank wants to keep its net interest income immune from changes in interest rates, it must closely monitor and manage its GAP carefully. Net interest income is the difference between interest income and interest expenses. NIl = Interest Income- Interest Expenses Changes in interest rates only affect the RSAs and RSLs over the planning horizon. The fixed rate assets and fixed rate liabilities are not affected by changes in interest rate. Thus: Li NIl = RSAs x Li ra- RSL x Li rl Where Li ra = change in interest rate on RSAs Li rl = change in interest rate on RSLs, If Li ra= Li rl r i.e. changes in interest rate on RSAs and RSLs is the same for the time period chosen then the change in net interest incorne can be written as Li NIl = (RSAs - RSLs) x Lir Since GAP was earlier expressed as a difference between RSAs and RSLs, a relationship can be expressed between a change in interest rates and a change in the bank's net interest income. Li NIl = GAP x Li r It is thus evident that a bank can immunize its net interest income over a given planning horizon by eliminating its funding Gap or when its RSAs are equal to its RSLs. Active Gap management requires the monitoring of all markets within which the institution operates plus the willingness to use interest rate forecasts as the basis for active asset/liability management. Ifthe bank management wants to completely insulate the balance sheet from changes in interest rates, the Gap would be set near to zero so that changes in asset return would be counterbalanced by changes in liability costs, irrespectiveofthe direction of interest rates. If a decline in interest rate was forecasted, the asset! liability strategywouldtry to narrowthe Gap, so that the proportion ofrate sensitive assets is reduced. In case a rise in interest rate is anticipated, the opposite strategy, increasing the size of the Gap would be attempted. In addition to the direction of interest rates, Gap management strategies also depend upon the volatility ofinterest rates. In periods ofhigh interest rate volatility, aggressive positioning with respect to the direction of interest rates is generally not advisable as the accuracy of interest rate forecasts are subject to a high degree of prediction error. SECTION 3 LIQUIDITY RISK ANALYSIS Measuring and managing liquidity risk is an important dimension ofalm. Mismatch in the maturity profile of assets and liabilities exposes the balance sheet to liquidity risk. As per the RBI guidelines, while the VISION-The Journal of Business Perspective Vol. 9 No.1 January-March 2005

5 Managing Gap: A Case Study Approach to Asset-Liability Management ofbanks. 53 mismatches up to one year would be relevant since these provide early warning signals, the main focus should be on the short-term mismatches, Le., 1-14 days and 15 to 28 days. Banks are expected to monitor their cumulative mismatches across all time buckets by establishing internal prudential limits with the approval ofthe Board/ Management Committee. Table 1 gives the maturity pattern of assets and liabilities ofthe four banks for the next 5 years. According to Table 1, Citi bank is maintaining a negative cumulative gap for most of the buckets of maturities. This reflects the banks' expectations of interest rate movements in the future. The strategy that Citibank is following is a sound one, as it will help the Table 1: Liquidity Risk Assessment of Banks, 2003 bank to take advantage of the falling interest rates by increasing the NIl. However, this strategy is not without risk. Since all the shorter duration gaps are negative, a sudden firming up of interest rates will sharply reduce the NIl ofthe bank. The assets and liabilities profile of ICICI bank reveal that the bank has a positive cumulative gap in case ofthe very short term bucket of 1-14 days and days and for over 5 years bucket. For all-the other maturity buckets, ICICI is maintaining a negative gap. The ALM of the bank is quite sound for the current falling interest rate scenario. However, it shall have to be very vigilant about a possible interest rate reversal in the near future and adjust its asset-liability profile Rs. Lakhs Time Bucket 1-14 / days- 3 Months- 6 Months- / Year- 3 Years- Over Total days Days 3 months 6 Months 1year 3 Years 5 Years 5 Years Citi Bank Rate Sensitive Assets Rate-Sensitive Liabilities Gap Cumulative Gap ICICI Bank Rate Sensitive Assets Rate Sensitive Liabilities Gap Cumulative Gap lobi Bank Rate Sensitive Assets Rate Sensitive Liabilities Gap Cumulative Gap SBI Bank Rate Sensitive Assets Rate Sensitive Liabilities ? Gap Cumulative Gap VISION-The Journal ofbusiness Perspective - Vol. 9 - No. 1-1anuary-March 2005

6 54. Vij accordingly. Various instruments to manage IRR can be employed by ICICI bank to guard against such an eventuality. These include interest rate swaps, interest rate futures and options, interest rate caps and collar. lobi bank is also maintaining a negative cumulative gap for most ofthe maturity buckets. This is probably an intentional strategy adopted by the bank to take advantage of the current falling interest rate scenario. State Bank of India is having a positive cumulative gap for all the buckets of maturities except one year to three years and three years to five years. A positive cumulative gap for the short term is clearly not a desirable strategy that SBI is following in the context of a falling interest rate scenario. The bank will probably face liquidity risk in the short terrn if it does not change its pattern ofmanaging its assets and liabilities. INTEREST RATE RISK The objective ofany financial institutions is to maintain interest rate risk at a level as close to zero as possible. However, many times management takes on interest rate Table 2: Interest Rate Risk Analysis of Banks, 2003 Rs. Lakhs Time Bucket days- 3 Months- 6 Months- 1 Year- 3 Years- Over Total days Days 3 months 6 Months 1 year 3 Years 5 Years 5 Years Change ofnil = Gap x ( Change in interest rate) -50 basis point Rate Sensitive Assests Citi ICICI IDBl SBl Cumulative Citi lcici IDBl SBI basis point Citi ICICI IDBI SBI ; Cumulative Citi ICICI lobi ] SBl ] t ]4 - VISION-The Journal ofbusiness Perspective. Vol. 9..No.1. January-March 2005

7 Managing Gap: A Case Study Approach to Asset-Liability Management ofbanks. 55 risk if it improves their ability to accomplish long-range profitability, growth, capitalization and dividend goals. These managers set policy limits that keep potential losses due to adverse movements in market rates at affordable levels. They see interest rate risk in the same way they see credit risk-an opportunity to make money through effective risk management (Torn Farin, 2001). Two different interest rate scenarios and their effects on the net interest income ofthe banks have been considered in this section. This type of analysis is important for the bank in order to adjust its asset-liability profile to minimize the negative effects of probable interest scenarios on its NIL Also it can use this information to hedge its risk using various instruments, e.g., interest rate swaps, forward rate agreement, caps, collars etc. Table 2 shows the interest rate risk for the four banks. The two different scenarios analyzed are: Scenario 1: Scenario 2: Interest rates decrease by 50 basis points. Interest rates increase by 100 basis points The forecasting period analyzed is for the next one year. The impact of both a falling interest rate and an increasing interest rate on the RSAs and RSls as well as on the NIl ofthe four banks has been analyzed. As Citibank has a negative cumulative gap, the decrease in interest rates by 50 basis points will have a positive impact and the NIl of the bank is expected to rise by Rs crores for a period less than one year. However, if the interest rates were to rise in the future, say by 100 basis points, the NIl of the bank would decrease by Rs crores for a period less than one year. This scenario is clearly not desirable for the bank especially in the short-term; although in the current falling interest rate regime it seems unlikely for some time to come. ICICI bank is maintaining a positive gap for the very short term buckets of 1-14 days and days but has a negative gap for a period less than one year. As shown in table 2, ifthe interest rates were to decrease by 50 basis points, the NIl of the bank would increase by Rs crores. Ifthe interest rates were to increase by 100 basis points, the Nil of the bank would fall by Rs crores. However, an increasing interest rate scenario is quite unlikely. For the long-term period, i.e., greater than 5 years, ICICI bank is maintaining a positive gap. Probably, the bank is expecting that the interest rates will finn up in the longer period. The NIl of the bank would increase by Rs crores for a period greater than five years ifthe interest rates were to increase by 100 basis points. Since lobi bank is maintaining a negative gap in all the maturity buckets, the NIl ofthe bank increases by Rs crores for a fall in the interest rates by 50 basis points (Table 2). But ifthe interest rates were to increase by 100 basis points, the NIl ofthe bank would fall by Rs crores. As SBI bank is maintaining a positive gap for a period less than one year, the NIl of the bank falls by Rs crores when the interest rates decrease by 50 basis points. This is clearly not.a very comfortable scenario for the bank as far as its short-term liquidity is concerned. However, if the interest rates were to increase by 100 basis points, the NIl ofthe bank increases by Rs crores. This seems to be an unlikely scenario keeping in view the current trend offalling interest rates. Hence, SBI need to monitor its RSAs and RSLs according to the movement in interest rates. Also, advanced and meticulous financial planning is required by banks so as to monitor their net interest income. Thus, banks should study and watch the interest rate movements carefully and also have sufficient flexibility to change its asset-liability portfolio according to movement in interest rates. Risk is an inalienable accessory of the financial intermediation business and banks recognizes the importance of robust risk management for building up a quality asset portfolio as well as for ensuring sustained profitability of its operations over the long-term period. The array and intensity of risks to which banks are currently exposed have multiplied in recent years as a result of the dismantling of the system of administered rates and pervasive domestic and international competitive pressures on domestic financial sector participants. Banks should accordingly adopt an ALM technique that can withstand various levels of risk exposure and still remain within the tolerable level of risks set by management. In addition to the maturity gap technique, RBI is making special efforts for introducing modern techniques like Duration analysis, Simulation and Value at Risk for managing IRR. But for this, the IT services need to be strengthened in banks. VISION-The Journal ofbusiness Perspective Vol. 9 No.1.January-March 2005

8 56. Vij Table 3: ComparativeAnalysis among Banks, 2003 Rs. Lakhs Time Bucket days- 3 Months- 6 Months- 1 Year- 3 Years- Over days Days 3 months 6 Months 1year 3 Years 5 Years 5 Years Change ofnil = Gap x ( Change in interest rate) I Liquidity Risk Assessment Gap (% oftotal asset) Citi % -6.91% 0.70% 6.00% A» -2.24% 2.12% 12.02% ICICI 0.09% 0.63% /0-1.58% -7.01% /0 6.47% 22.41% lobi % -4.22% /0-1.54% -1.27% -9.19% 4.05% 29.35% SBI 3.980/0 2.18% 4.050/0 1.92% -7.03% % 3.72% 22.38% Cumulative Gap (0/0 of total asset) Citi % / / % % % % A» ICICI 0.09% 0.72% -2.71% -4.29% % % % 11.16% lobi % % % % % % % -2.95% SBI 3.98% 6.16% 10.21% 12.13% 5.10% % % 3.57% Foreign Currency Gap (% oftotal asset) Citi -3.91% -1.25% A» 0.670/0-3.43% 3.38% 0.28% 0.00% ICICI IDBI 0.14% 0.15% 0.350/ /0 0.29% -0.96% 0.050/0-0.92% SBI 1.91% 0.210/ /0 0.98% 0.00% -1.02% 0.29% 0.11% Cumulative Foreign Currency Gap ( % oftotal asset) Citi -3.91% -5.16% /0-5.66% -9.09% -5.71% -5.43% -5.43% ICICI lobi 0.14% 0.29% 0.64% 1.540/0 1.83% 0.87% 0.92% 0.00% SBI 1.91% 2.12% 2.940/0 3.92% 3.92% 2.900/0 3.19% 3.30% Change ofnil = Gap x ( Change in interest rate) -50 basis point % oftotal asset Citi 0.07% 0.03% 0.00% -0.03% 0.040/0 0.01% /0-0.06% ICICI O.OO A» 0.00% 0.020/ /0 0.04% 0.03% -0.03% /0 lobi 0.080/0 0.02% 0.02% 0.01% -0.01% 0.04% -0.02% -0.15% SBI -0.02% -0.01% -0.02% /0 0.04% 0.140/0-0.02% /0 Cumulative Citi 0.07% 0.10% 0.100/0 0.07% 0.110/0 0.12% 0.110/0 0.05% ICICI 0.00% 0.00% 0.02% 0.03% 0.07% 0.10% 0.07% -0.05% lobi 0.08% 0.10% 0.12% 0.13% 0.12% 0.16% 0.140/0-0.01% SBI -0.02% -0.03% -0.05% -0.06% -0.02% 0.12% 0.10% -0.01% +100 basis point % oftotal asset Citi -0.14% -0.01% % -0.09% -0.02% 0.02% 0.12% ICICI % -0.03% /0-0.07% -0.06% 0.06% 0.22% lobi -0.16% -0.04% -0.04% -0.02% -0.01% -0.09% 0.04% 0.29% SBI 0.040/0 0.02% 0.04% 0.02% -0.07% -0.27% 0.03% 0.22% Cumulative Citi -0.14% -0.21% -0.21% -0.15% -0.24% -0.26% -0.24% -0.12% ICICI 0.00% 0.01% -0.03% -0.04% -0.11% -0.17% -0.11% 0.11% lobi -0.16% -0.20% -0.24% -0.26% -0.27% /0-0.32% -0.03% SBI 0.04% 0.060/ A» 0.12% 0.050/0-0.22% -0.19% 0.030/0 VISION-The Journal ofbusiness Perspective. Vol. 9.No.1. January-March 2005

9 Managing Gap: A Case Study Approach to Asset-Liability Management ofbanks. 57 COMPARATIVE ANALYSIS Gap Analysis and Interest Rate Risk When we consider cumulative gaps ofall banks, we find that lobi was in the best position among the four banks under study. As indicated in Table 3, it had a gap of-2.95 per cent of total assets. This means that in the long run lobi would be in the best position among the four banks to deal with the interest rate volatility. At the same time, Citibank had the highest gap among banks in the long run, that is per cent of total assets. The other two banks-icici and SBI-had cumulative gaps of per cent and 3.57 per cent respectively. These facts are consistent with the interest shock simulation, in the long run. lobi would be relatively least affected by interest shocks, while Citibank would be hit hardest if the shock occurs. Also, lobi would be least exposed to the interest rate risk in the long term. In the short run i.e., less than twelve months, SBI had the narrowest gap among the four banks. It had a cumulative gap of 5.10 per cent of total assets, whereas lobi had the widest gap, per cent oftotal assets, for the same period. The other two banks had relatively high negative gaps, more than 10 per cent, for the bucket that is shorter than one year. This implies that all the banks, except SBI, preferred to take advantage of the declining interest rate movement in India. For the last few years, RBI had a policy of soft interest rate, constantly cutting down the rate. Citi bank and lobi bank were the two banks that had gained most from the policy. Foreign Currency Risk In the long run, lobi seems to be in the best position among the banks. It had a zero balance of foreign currency asset/liability. This would keep them secure from any foreign exchange volatility. Citi Bank funded its foreign currency assets through long-term liability in foreign currency. Most of their foreign liability will mature after five years. This might imply that Citibank takes advantage of cheap offshore funds and India's relatively high interest rate. ICICI bank had a low foreign currency gap, per cent while SBI had a positive foreign currency gap (3.30 per cent). In the short run only ICrCI had the narrowest negative gap of-1.9 per cent among the four banks. Citi bank had the highest gap of-9.09 per cent oftotal assets. The other two banks, lobi and SBI had positive foreign currency gaps, i.e., 1.83 per cent and 3.92 per cent respectively. This implies that in the present trend of falling interest rate scenario, their NIl would decrease. CONCLUSIONS According to Balino and Ubide (2000), the banking sector is entering a new world in which national and institutional boundaries are becoming less important. Inevitably, supervisory and regulatory systems will have to adapt their work methods in order to remain effective. Technology has also revolutionized the banking industry in a big way, and today banks cannot afford to ignore the importance of ALM. This is the function that will help banks and financial institutions to keep their profit margins intact, and is, perhaps, the only way for banks to survive in the changing environment where the composition, duration and risk profile oftheir assets and liabilities have an important bearing on their growth and profitability. Technology has also helped banks to improve their product delivery and profitability. Switching to other distribution channels like ATMs, Tele-banking, etc., have helped banks not only to improve their customer service but to also reduce transaction costs. ATMs have been gaining popularity and Tele-banking and Internet banking are also becoming popular, as the convenience factor creates a very favorable impression on the minds of bank customers. Of late, RBI has started stressing on the importance of setting up a good MIS system by banks. For the traditional gap analysis to be effective and successful, banks have realized that the presence of an effective MIS system is imperative. It will facilitate managers to forecast income and portfolio values based on different interest rate assumptions by using various sophisticated models and advanced techniques offorecasting. In most ofthe developed countries, banks are using advanced software for ALM. In order to favorably compare with International standards, Indian banks need to adopt the latest market driven strategies so as to favorably compete and be compared with banks in other developed countries. Also, in the context ofthe differing environment and the diverse nature of activities undertaken by different banks, the process ofalm will differ from bank to bank and the success of the technique will depend upon how effectively the banks are able to forecast and manage the risk they carry and are exposed to. Rajwade (2002) has argued that the prompt availability of assets and liabilities data, in particular residual maturities, as also off-balance sheet transactions like interest rate swaps, is the key to an effective ALM strategy. This would present a major challenge to banks in India, which may not be optimally computerized. VISION-The Journal ofbusiness Perspective Vol. 9 No.1. January-March 2005

10 58. Vij REFERENCES Balino, Tomas, 1. and Ubide, Angel (2000), "The New World of Banking," Finance and Development, June. Byrne, Jim (2000), "Bringing Banking Risk Up To Date," Balance Sheet, Bradford: Vol. 8, No.6 Farin, TOlTI (2001), "Developing a Dynamic Interest Rate Risk Management Program," Journal offinance, May-June. Moynihan, G.Purushothaman, P. McLeod, M. and.nichols, G. (2002), "DSSALM: A Decision Support System for Asset and Liability Management," Patrick Totty (2003), "Demystifying ALM," Credit Union Magazine, August. Rajwade, A.V. (2002), "Issues in Asset Liability Management," Economic and Political Weekly, February. Randall, Payant, W. (2000), "Making Asset Liability Management Performance Count," Bank Accounting and Finance, (Euromoney Publications) Fall, Vol. 14, No. 1. Susie Fair (2003), "The Yellow Brick Road to ALM Success," Credit Union Magazine, August. Taylor, Jeremy F. (2001), "The Rational Management of Liquidity Risk," Bank Accounting and Finance, Euromoney Publications, Fall, Vol. 15 Issue I. Madhu Vij, Ph.D. (dramadhuvijtghotmail.com) is an Associate Professor at the Faculty ofmanagement Studies, (FMS), University of Delhi where she teaches International and Corporate Finance. Her specialization includes: International Financial Management, Management of Financial Services, Management of Financial Institutions, Financial and Management Accounting. She has recently completed a project sanctioned by the UGC on 'Asset Liability Management in Banks and Financial Institutions.'Currently, she is working on a project sanctioned by ICSSR on 'Capital Flows in a Globally Competitive Environment: Implications ofchanging Country Risk Rating'. Dr Vij is the author offour books and has contributed several articles in managementjournals in the field ofbanking and finance. She has also presented a number of papers in national and international conferences. She is actively involved with a number of training programme conducted by FMS and is currently the Management Science Association and Placement advisor at FMS. VISION-The Journal ofbusiness Perspective Vol. 9 No.1. January-March 2005