To

All India Financial Institutions
(ICICI, IDBI, IFCI, IDFC, TFCI, IIBI, NABARD, NHB, SIDBI and EXIM Bank)

Dear Sir,

As you are aware, the final guidelines for introduction of ALM system by banks have been recently issued by RBI and the system has become operational w.e.f. 1 April 1999. Since the operations of financial institutions also give rise to liquidity and interest rate risk exposures, it has been decided to introduce an ALM system for the all-India financial institutions as well, as part of their overall system for effective risk management in their various portfolios.

2. We forward herewith the broad draft guidelines for measurement of liquidity and interest rate risk which could form the basis for evolving an ALM system by the FIs. The intention of issuing these guidelines is to sensitise the managements of FIs to the need for a formally structured management of the liquidity and interest rate risk of their portfolios and to provide a basis for initiating measures for collection, compilation and analysis of data required for an effective ALM system. The FIs may study the draft guidelines and offer their suggestions on the aspects where there are likely to be practical difficulties in implementing the guidelines latest by 30 June 1999.

3. The guidelines are expected to be particularly useful for the FIs which do not have a formal and well structured ALM system. However, if any of the FIs already have more sophisticated ALM systems in place, they may continue with the same but should fine tune their reporting systems, where necessary, so as to conform to the prescribed guidelines . It would be desirable to constitute a small Group under the charge of the senior executive responsible for treasury function of the institution, with members drawn from investments, foreign exchange, credit and MIS areas. The Group should be entrusted with the task of carrying out necessary spade work for formalising the ALM system in the institution.

4. We would like the financial institutions to introduce the ALM system w.e.f. 1^st October 1999 on a trial run basis so that they are in a position to switch over to a regular ALM system from 1^st April 2000.

5. Please acknowledge receipt.

Yours faithfully,

(K. C. Bandyopadhyay)
Chief General Manager

Encl: as above

In the normal course, FIs are exposed to credit and market risks in view of the asset-liability transformation. With liberalisation in Indian financial markets over the last few years and growing integration of domestic markets and with external markets, the risks associated with FIs' operations have become complex and large, requiring strategic management. FIs are now operating in a fairly deregulated environment and are required to determine on their own, interest rates on deposits and advance in both domestic and foreign currencies on a dynamic basis. The interest rates on FIs' investments in government and other securities are also now market related. Intense competition for business involving both the assets and liabilities, together with increasing volatility in the domestic interest rates as well as foreign exchange rates, has brought pressure on the management of FIs to maintain a good balance among spreads, profitability and long-term viability. Imprudent liquidity management can put FIs’ earnings and reputation at great risk. These pressures call for structured and comprehensive measures and not just ad hoc action. The Management of FIs has to base their business decisions on a dynamic and integrated risk management system and process, driven by corporate strategy. FIs are exposed to several major risks in the course of their business - credit risk, interest rate risk, foreign exchange risk, equity / commodity price risk , liquidity risk and operational risk. It is, therefore, important that FIs introduce effective risk management systems that address the issues related to interest rate, currency and liquidity risks.

FIs need to address these risks in a structured manner by upgrading their risk management and adopting more comprehensive Asset-Liability Management (ALM) practices than has been done hitherto. ALM, among other functions, is also concerned with risk management and provides a comprehensive and dynamic framework for measuring, monitoring and managing liquidity, interest rate, foreign exchange and equity and commodity price risks of a bank that needs to be closely integrated with the FIs’ business strategy. It involves assessment of various types of risks and altering the asset-liability portfolio in a dynamic way in order to manage risks.

2. This note lays down broad guidelines in respect of interest rate and liquidity risks management systems in FIs which form part of the Asset-Liability Management (ALM) function. The initial focus of the ALM function would be to enforce the risk management discipline viz. managing business after assessing the risks involved. The objective of good risk management systems should be that these systems will evolve into a strategic tool for FIs management.

3. The ALM process rests on three pillars:

• ALM Information Systems

• Management Information Systems
• Information availability, accuracy, adequacy and expediency

• ALM Organisation

• Structure and responsibilities
• Level of top management involvement

• ALM Process

• Risk parameters
• Risk identification
• Risk measurement
• Risk management
• Risk policies and tolerance levels.

4. ALM Information Systems

ALM has to be supported by a management philosophy which clearly specifies the risk policies and tolerance limits. This framework needs to be built on sound methodology with necessary information system as back up. Thus, information is the key to the ALM process. It is, however, recognised that varied business profiles of FIs in the public and private sector do not make the adoption of a uniform ALM System for all FIs feasible. There are various methods prevalent world-wide for measuring risks. These range from the simple Gap Statement to extremely sophisticated and data intensive Risk Adjusted Profitability Measurement methods. However, the central element for the entire ALM exercise is the availability of adequate and accurate information with expedience and the existing systems in many FIs do not generate information in the manner required for ALM. Collecting accurate data in a timely manner will be the biggest challenge before the FIs, particularly lacking full scale computerisation. However, the introduction of base information system for risk measurement and monitoring has to be addressed urgently. As FIs are aware, internationally, regulators have prescribed or are in the process of prescribing capital adequacy for market risks. A pre-requisite for this is that FIs must have in place an efficient information system.

Considering the large network of branches and the lack of (an adequate) support system to collect information required for ALM which analyses information on the basis of residual maturity and behavioural pattern, it will take time for FIs in the present state to get the requisite information. In respect of foreign exchange, investment portfolio and money market operations, in view of the centralised nature of the functions, it would be much easier to collect reliable information. The data and assumptions can then be refined over time as the FI management gain experience of conducting business within an ALM framework. The spread of computerisation will also help FIs in accessing data.

5. ALM Organisation

5.1 a) Successful implementation of the risk management process would require strong commitment on the part of the senior management in the FI, to integrate basic operations and strategic decision making with risk management. The Board should have overall responsibility for management of risks and should decide the risk management policy of the FI and set limits for liquidity, interest rate, foreign exchange and equity price risks.

b) The Asset - Liability Committee (ALCO) consisting of the FI's senior management including CEO should be responsible for ensuring adherence to the limits set by the Board as well as for deciding the business strategy of the FI (on the assets and liabilities sides) in line with the FI’s budget and decided risk management objectives.

c) The ALM Support Groups consisting of operating staff should be responsible for analysing, monitoring and reporting the risk profiles to the ALCO. The staff should also prepare forecasts (simulations) showing the effects of various possible changes in market conditions related to the balance sheet and recommend the action needed to adhere to FI's internal limits.

5.2 The ALCO is a decision making unit responsible for balance sheet planning from risk -return perspective including the strategic management of interest rate and liquidity risks. Each FI will have to decide on the role of its ALCO, its responsibility as also the decisions to be taken by it. The business and risk management strategy of the FI should ensure that the FI operates within the limits / parameters set by the Board. The business issues that an ALCO would consider, inter alia, will include product pricing for both deposits and advances, desired maturity profile and mix of the incremental assets and liabilities, etc. In addition to monitoring the risk levels of the FI, the ALCO should review the results of and progress in implementation of the decisions made in the previous meetings. The ALCO would also articulate the current interest rate view of the FI and base its decisions for future business strategy on this view. In respect of the funding policy, for instance, its responsibility would be to decide on source and mix of liabilities or sale of assets. Towards this end, it will have to develop a view on future direction of interest rate movements and decide on funding mixes between fixed vs floating rate funds, wholesale vs retail deposits, money market vs capital market funding , domestic vs foreign currency funding, etc. Individual FIs will have to decide the frequency for holding their ALCO meetings.

5.3 Composition of ALCO

The size (number of members) of ALCO would depend on the size of each institution, business mix and organisational complexity. To ensure commitment of the Top Management and timely response to market dynamics, the CEO/CMD or the ED should head the Committee. The Chiefs of Investment, Credit, Resources Management or Planning, Funds Management / Treasury (forex and domestic), International Business and Economic Research can be members of the Committee. In addition, the Head of the Technology Division should also be an invitee for building up of MIS and related computerisation. Some FIs may even have Sub-committees and Support Groups.

5.4 Committee of Directors

The Management Committee of the Board or any other Specific Committee constituted by the Board should oversee the implementation of the system and review its functioning periodically.

5.5 ALM Process:

• Liquidity risk management
• Management of market risks
• Trading risk management
• Funding and capital planning
• Profit planning and growth projection

The guidelines given in this note mainly address Liquidity and Interest Rate risks.

6. Liquidity Risk Management

6.1 Measuring and managing liquidity needs are vital for effective operation of FIs. By assuring a FI's ability to meet its liabilities as they become due, liquidity management can reduce the probability of an adverse situation developing. The importance of liquidity transcends individual institutions, as liquidity shortfall in one institution can have repercussions on the entire system. FIs management should measure not only the liquidity positions of FIs on an ongoing basis but also examine how liquidity requirements are likely to evolve under different assumptions. Experience shows that assets commonly considered, as liquid like Government securities and other money market instruments could also become illiquid when the market and players are unidirectional. Therefore liquidity has to be tracked through maturity or cash flow mismatches. For measuring and managing net funding requirements, the use of a maturity ladder and calculation of cumulative surplus or deficit of funds at selected maturity dates is adopted as a standard tool. The format of the Statement of Structural Liquidity is given in Annexure I.

6.2 The Maturity Profile as given in Appendix I could be used for measuring the future cash flows of FIs in different time buckets. The time buckets, may be distributed as under:

1. 1 to 14 days
2. 15 to 28 days
3. 29 days and upto 3 months
4. Over 3 months and upto 6 months
5. Over 6 months and upto 1 year
6. Over 1 year and upto 3 years
7. Over 3 years and upto 5 years
8. Over 5 years and upto 7 years
9. Over 7 years and upto 10 years
10. Over 10 years.

6.3 The investments are assumed as illiquid due to lack of depth in the secondary market and are therefore required to be shown under respective maturity buckets, corresponding to the residual maturity. However, some of the FIs may be maintaining securities in the ‘Trading Book’, which are kept distinct from other investments made for retaining relationship with customers. Securities held in the 'Trading Book’ are subject to certain preconditions like :

1. The composition and volume are clearly defined;
2. Maximum maturity/duration of the portfolio is restricted;
3. The holding period not to exceed 90 days;
4. Cut-loss limit prescribed;
5. Defeasance periods (product-wise) i.e. time taken to liquidate the position on the basis of liquidity in the secondary market are prescribed;
6. Marking to market on a daily/weekly basis and the revaluation gain/loss charged to the profit and loss account; etc.

FIs which maintain such ‘Trading Books’ and complying with the above standards are permitted to show the trading securities under 1-14 days, 15-28 days and 29-90 days buckets on the basis of the defeasance periods. The Board/ALCO of the FIs should approve the volume, composition, holding/defeasance period, cut loss, etc. of the ‘Trading Book’ and copy of the policy note thereon should be forwarded to the Department of Banking Supervision, FID, RBI.

6.4 Within each time bucket there could be mismatches depending on cash inflows and outflows. While the mismatches upto one year would be relevant since these provide early warning signals of impending liquidity problems, the main focus should be on the short-term mismatches viz., 1-14 days and 15-28 days. FIs however, are expected to monitor their cumulative mismatches (running total) across all time buckets by establishing internal prudential limits with the approval of the Board / Management Committee. The mismatches (negative gap) during 1-14 days and 15-28 days in normal course may not exceed 5% of the cash outflows in each time bucket. If a FI in view of its current asset -liability profile and the consequential structural mismatches needs higher tolerance level, it could operate with higher limit sanctioned by its Board / Management Committee giving specific reasons on the need for such higher limit. The discretion to allow a higher tolerance level is intended for a temporary period, i.e. till March 31, 2000.

6.5 The Statement of Structural Liquidity ( Annexure I ) may be prepared by placing all cash inflows and outflows in the maturity ladder according to the expected timing of cash flows. A maturing liability will be a cash outflow while a maturing asset will be a cash inflow. It would also be necessary to take into account the rupee inflows and outflows on account of forex operations. While determining the likely cash inflows / outflows, FIs have to make a number of assumptions according to their asset - liability profiles. While determining the tolerance levels the FIs may take into account all relevant factors based on their asset-liability base, nature of business, future strategy, etc. The RBI is interested in ensuring that the tolerance levels are determined keeping all necessary factors in view and further refined with experience gained in Liquidity Management.

6.6 In order to enable the FIs to monitor their short-term liquidity on a dynamic basis over a time horizon spanning from 1 day to 6 months, FIs may estimate their short-term liquidity profiles on the basis of business projections and other commitments for planning purposes. An indicative format ( Annexure III ) for estimating Short-term Dynamic Liquidity is enclosed.

7. Currency Risk

7.1 Floating exchange rate arrangement has brought in its wake pronounced volatility adding a new dimension to the risk profile of FIs’ balance sheets. The increased capital flows across free economies following deregulation have contributed to increase in the volume of transactions. Large cross border flows together with the volatility has rendered the FIs' balance sheets vulnerable to exchange rate movements.

7.2 Dealing in different currencies brings opportunities as also risks. If the liabilities in one currency exceed the level of assets in the same currency, then the currency mismatch can add value or erode value depending upon the currency movements. The simplest way to avoid currency risk is to ensure that mismatches, if any, are reduced to zero or near zero. FIs undertake operations in foreign exchange like borrowings, making loans and advances and quoting prices for foreign exchange transactions. Irrespective of the strategies adopted, it may not be possible to eliminate currency mismatches altogether. Besides, some of the institutions may take proprietary trading positions as a conscious business strategy.

7.3 Managing Currency Risk is one more dimension of Asset- Liability Management. Mismatched currency position besides exposing the balance sheet to movements in exchange rate also exposes it to country risk and settlement risk. Following the introduction of "Guidelines for Internal Control over Foreign Exchange Business" in 1981, maturity mismatches (gaps) are also subject to control. Following the recommendations of Expert Group on Foreign Exchange Markets in India (Sodhani Committee) the calculation of exchange position has been redefined and FIs have been given the discretion to set up overnight limits linked to maintenance of capital to Risk-Weighted Assets Ratio of 8% of open position limit.

7.4 Presently, the FIs are also free to set gap limits with RBI’s approval but are required to adopt Value at Risk (VaR) approach to measure the risk associated with forward exposures. Thus the open position limits together with the gap limits form the risk management approach to forex operations. For monitoring such risks FIs should follow the instructions contained in Circular A.D (M. A. Series) No.52 dated December 27, 1997 issued by the Exchange Control Department.

8. Interest Rate Risk (IRR)

8.1 The phased deregulation of interest rates and the operational flexibility given to FIs in pricing most of the assets and liabilities imply the need for the financial system to hedge the Interest Rate Risk. Interest rate risk is the risk where changes in market interest rates might adversely affect a FI's financial condition. The changes in interest rates affect FIs in a larger way. The immediate impact of changes in interest rates is on FI's earnings (i.e. reported profits) by changing its Net Interest Income (NII). A long-term impact of changing interest rates is on FI's Market Value of Equity (MVE) or Net Worth as the economic value of FI’s assets, liabilities and off-balance sheet positions get affected due to variation in market interest rates. The interest rate risk when viewed from these two perspectives is known as ‘earnings perspective’ and ‘economic value’ perspective, respectively. The risk from the earnings perspective can be measured as changes in the Net Interest Income (NII) or Net Interest Margin (NIM). There are many analytical techniques for measurement and management of Interest Rate Risk. In the context of poor MIS, slow pace of computerisation in FIs, the traditional Gap analysis is considered as a suitable method to measure the Interest Rate Risk in the first place. It is the intention of RBI to move over to the modern techniques of Interest Rate Risk measurement like Duration Gap Analysis, Simulation and Value at Risk over time when FIs acquire sufficient expertise and sophistication in acquiring and handling MIS.

The Gap or Mismatch risk can be measured by calculating Gaps over different time intervals as at a given date. Gap analysis measures mismatches between rate sensitive liabilities and rate sensitive assets (including off-balance sheet positions). An asset or liability is normally classified as rate sensitive if:

1. within the time interval under consideration, there is a cash flow;
2. the interest rate resets/reprices contractually during the interval;
3. dependent on RBI changes in the interest rates/Bank Rate;
4. it is contractually pre-payable or withdrawal before the stated maturities.

8.2 The Gap Report should be generated by grouping rate sensitive liabilities, assets and off-balance sheet positions into time buckets according to residual maturity or next repricing period, whichever is earlier. The difficult task in Gap analysis is determining rate sensitivity. All investments, advances, deposits, borrowings, purchased funds, etc. that mature/reprice within a specified timeframe are interest rate sensitive. Similarly, any principal repayment of loan is also rate sensitive if the FI expects to receive it within the time horizon. This includes final principal payment and interim instalments. Certain assets and liabilities receive/pay rates that vary with a reference rate. These assets and liabilities are repriced at pre-determined intervals and are rate sensitive at the time of repricing. While the interest rates on term deposits are fixed during their currency, the tranches of advances portfolio is basically floating. The interest rates on advances could be repriced any number of occasions, corresponding to the changes in PLR.

The Gaps may be identified in the following time buckets:

1. 1-28 days
2. 29 days and upto 3 months
3. Over 3 months and upto 6 months
4. Over 6 months and upto 1 year
5. Over 1 year and upto 3 years
6. Over 3 years and upto 5 years
7. Over 5 years and upto 7 years
8. Over 7 years and upto 10 years
9. Over 10 years
10. Non-sensitive

The various items of rate sensitive assets and liabilities and off-balance sheet items may be classified as explained in Appendix - II and the Reporting Format for interest rate sensitive assets and liabilities is given in Annexure II.

8.3 The Gap is the difference between Rate Sensitive Assets (RSA) and Rate Sensitive Liabilities (RSL) for each time bucket. The positive Gap indicates that it has more RSAs than RSLs whereas the negative Gap indicates that it has more RSLs. The Gap reports indicate whether the institution is in a position to benefit from rising interest rates by having a positive Gap (RSA > RSL) or whether it is in a position to benefit from declining interest rates by a negative Gap (RSL > RSA). The Gap can, therefore, be used as a measure of interest rate sensitivity.

8.4 Each FI should set prudential limits on individual Gaps with the approval of the Board/Management Committee. The prudential limits should have a relationship with the Total Assets , Earning Assets or Equity. The FIs may work out Earnings at Risk (EaR) or Net Interest Margin (NIM) based on their views on interest rate movements and fix a prudent level with the approval of the Board/Management Committee.

8.5 RBI will also introduce capital adequacy for market risks in due course.

9. General

9.1 The classification of various components of assets and liabilities into different time buckets for preparation of Gap reports (Liquidity and Interest Rate Sensitivity) as indicated in Appendices I & II is the benchmark. FIs which are better equipped to reasonably estimate the behavioural pattern, embedded options, rolls-in and rolls-out, etc of various components of assets and liabilities on the basis of past data / empirical studies could classify them in the appropriate time buckets, subject to approval from the ALCO / Board. A copy of the note approved by the ALCO / Board may be sent to the Department of Banking Supervision, Financial Institutions Division.

9.2 The present framework does not capture the impact of embedded options, i.e. the customers exercising their options (premature closure of deposits, bonds and prepayment of loans and advances) on the liquidity and interest rate risks profile of FIs. The magnitude of embedded option risk at times of volatility in market interest rates is quite substantial.. FIs should therefore evolve suitable mechanism, supported by empirical studies and behavioural analysis to estimate the future behaviour of assets, liabilities and off-balance sheet items to changes in market variables and estimate the embedded options.

9.3 A scientifically evolved internal transfer pricing model by assigning values on the basis of current market rates to funds provided and funds used is an important component for effective implementation of ALM System. The transfer price mechanism can enhance the management of margin i.e. lending or credit spread, the funding or liability spread and mismatch spread. It also helps centralising interest rate risk at one place which facilitate effective control and management of interest rate risk. A well defined transfer pricing system also provide a rational framework for pricing of assets and liabilities.

Heads of Accounts Time-bucket category

1. Outflows

1. Any event-specific cash flows (e.g. outflow due to wage settlement arrears, capital expenses, income tax refunds, etc.) should be shown in a time bucket corresponding to timing of such cash flows.
2. All overdue liabilities be shown in the 1 to 14 days time bucket.

1. Overdue receivables on account of interest and instalments of standard loans should be slotted as below:

The negative gap (i.e. where outflows exceed inflows) in the 1 to 14 days and 15 - 28 days time-bucket should not exceed the prudential limit of 5 % of outflows of each time-bucket and the cumulative gap upto the one year period should not exceed 10% of the cumulative cash outflows upto one year period. In case these limits are exceeded, the measures proposed for bringing the gaps within the limit, should be shown by a footnote in the relative statement.