One of the key challenges of banks is to maintain equilibrium between inflows and outflows of funds, in terms of size and tenor.
The funds flow into the banks through deposits and they need to be deployed in the form of loans and advances at the choice of customers. The inflows will be for different time periods in varying size. These funds have to be applied to meet deployment needs as per the requirements of borrowers.
Banks use borrowings and lending in interbank call markets to bridge the gap. Banks are thus exposed to liquidity risk. In order to measure and mitigate the risk, it will be essential to use effective tools to avoid huge funding gaps.
Thus the concept of liquidity is increasingly becoming important in managing financial risk as banks begin to expand operations in globalized environment It is driven by; the structure and depth of markets; volatility of market prices/rates; the presence of traders willing to make markets and commit capital to support trading; and, trading / leverage strategies deployed. The management of liquidity can be seamless as the markets attain maturity.
At the strategic level, most banks will manage funding liquidity risk through the Asset Liability Management (ALM) process. In many smaller banks, however, it can be the responsibility of the treasury department that also has day to day responsibility for operationalizing the ALM strategy. Thus ALM can be defined as a mechanism to address the risk faced by a bank due to a mismatch between assets and liabilities either due to liquidity or changes in interest rates. Liquidity is an intuition ability to meet its liabilities either by borrowing or converting assets into liquidity.
The ALM process and strategy has to be accordingly aligned. With the advancement of technology and collection of data of tenure and maturity of liabilities, it has enabled scientific management of ALM process in banks.
Identifying ALM needs
There are different organizational and governance models that guide the management of ALM in banks to better align asset and liability activities. The models reflect fundamentally different risk philosophies that tend to evolve with the growing sophistication and depth of financial markets together with the position and activities undertaken by a bank in the given competition in the domestic financial markets.
In emerging markets, the treasury function is usually simplistic and a support function mainly focused on liquidity management and basic foreign exchange activity. In these banks, it is not uncommon to avoid exposure to more sophisticated capital markets transactions such as derivatives, futures, options, due to inadequate infrastructure and enhanced uncertainty and sometimes immeasurable risks inherent in such sophisticated instruments. Such markets can suffer from poorly developed capital markets that provide little capacity to offset the risks assumed from the customer franchise.
The result is often that such nuances may expose banks to run risks, without knowing ramifications and extent of damage it can cause to the overall profitability. Sometimes such consequences of use of instruments can threaten their very survival. Successful ALM processes need to create a properly aligned risk and return management process. The right mix between skills and risk appetite must be identified, expected outcomes of activities known and appropriate metrics established. The approach adopted needs to be aligned to the realities of the market the bank is operating within and to its desired risk appetite. Depending on the size and span of operations banks should be in a position to determine the extent to which mismatches can be handled by the system linked to the complexity of incremental rise in business volumes. The crux of ALM is the art and science of managing mismatches or funding gaps at least cost.
Mismatch management strategy
In a market-driven ecosystem, regulatory dispensation, it is essential for banks, as a policy perspective to take a pragmatic call whether it can assume a relatively neutral approach to ALM risks or can manage and adopt a more Vibrant approach, consciously allowing higher-funding gaps to take advantage of market movements to make money and target higher long term earnings.
Irrespective of the organizational philosophy to determine risk appetite, bank should keep in mind andneeds to realize that the right level of skills and resources have to be committed to support such key function.
Failure to support the policy with adequate technology infrastructure and competent work force may, in the long run prove to be a limitation that can lead to ALM, a poorly managed operation characterized by volatility impacting core earnings, diminishing of margins, economic value and ultimately reducing stake holder value.
Such is the umbilical link between ALM policy and stakeholder value. Hence, the mismatch management in funding operations need to be assumed as a critical function that decides the direction of growth of the organization.
Transfer price mechanism in ALM
The branches of banks as business units mobilize resources and deploy credit. Since the entire resources cannot be utilized at the branch level of credit and moreover, banks have to meet the statutory liquidity ratios prescribed by Central Bank, the funds from branches are transmitted to central pool of treasury for management of funds.
Hence the onus of management of surplus funds is the prerogative of treasury department of banks who also report ALM status to central bank. In order to provide an equitable distribution of revenues generated from the resources mobilized by bank branches, banks incorporate a well aligned internal Transfer Price Mechanism (TPM).
TPM enables banks to transfer revenues to branches at prescribed intervals at a rate to be determined depending on treasury yields so as to (i) keep branches encouraged to mobilize more resources for the banks (ii) Maintain the viability of branch operations (iii) Create systemic control on treasury to maintain ALM so as to create enough resources to fund TPM (iv) keep branches conscious of ALM needs of the bank (v) lend more as the yields from advances will always be greater than TPM.
Therefore ALM is an effective tool for cost-efficient management of funding gaps keeping in view the maturity ladder of assets and liabilities. The impact of efficient ALP transcends to enhance stakeholder value that increases the prospects of growth. The function of ALM therefore needs to be better aligned with broader policy dimensions and well calibrated systemic controls using the data analytic tools and setting the right risk appetite.
With integration of more sophistical technology, the tools of ALM are fast transforming into risk more scientific statistical management modules that has the potentiality to provide synergy to enhance profitability. ALM as an integral part of risk management strategy needs more focus to enhance stakeholder value.
(The author is Director, National Institute of Banking Studies and Corporate Management – NIBSCOM, Noida, India. The views are his own)
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