1. ASSET LIABILITY MANAGEMENT FINACIAL INSTITUTIONS & SERVICES

2. Sequence of Steps in ALM (Asset / Liability Management) ALM refers to simultaneous management of assets and liabilities of any financial institution to achieve its target RONW ( ROE). HOW IS IT DONE? 1. Managing the size of NIM 2. managing the risk of NIM Step1. Managing the size of NIM Set a RONW target for next year ( because co’s owners are most important, and the return on their investment is NI / OE) Given the regulation about Capital Adequacy and Tax rate, set NIM target for The next year to achieve the target RONW. Given the NIM target, set the targets for r (effective annual yield on assets) & c (effective annual yield on liabilities) Given the targets r on assets, decide the amounts and yields (‘r’s) of different types of assets you want to have in your balance sheet. Similarly given the target ‘c’ on liabilities, decide the amounts and yield (‘c’s) of different types of liabilities you want to have in your balance sheet.

3. Step 2. Managing the risk of NIM 1. By Restructuring the Balance Sheet a) Rate sensitive GAP management b) Duration GAP Mgmt. Please note the restructuring needed to manage rate sensitive GAP may not be suitable to manage Duration GAP. So there is possibility that the management strategy for rate sensitive gap ( also called funding GAP, Maturities mismatching GAP) may go counter to the strategy for Duration GAP management; and manager may face a dilemma as to which GAP to manage and which GAP to leave un managed.

4. 2. Without restructuring the Balance Sheet: by using financial derivative such as : i-rate Futures contracts i-rate Options contracts i- rate Swap contracts i-rate swap options i-rate Caps, floors you can achieve the same desired future CFs (cash flows) pattern by taking position in the above stated derivative contracts as you would achieve by restructuring the balance sheet.

5. Exercise: A financial Institution has target for RONW=30%. It earns 15% yield (r )on its assets, its tax rate is 60%. Govt.’s capital adequacy requirement is minimum 10%, its NIE / TA ratio is 2% and its TL / TA ratio = 90%. Required: What should be its cost of funds to achieve target RONW? (i.e. c) What should be is NIM to achieve target RONW? If Govt. changes the Capital Adequacy rules and brings it at par with the int’l standards (4%), then what RONW it can expect to earn, keeping the target NIM same as in no. 2 above.

6. Solution 1).NIM= {RONW * NW/TA * 1/(1-t)} + NIE/TA = r - (c * TL/TA) {0.3*0.10*1/(1-0.6)} + 0.02 = 0.15 - (c* 0.9) 0.095=0.15-0.90c 0.095 - 0.15= -0.90c -0.055= -0.90c 0.0611=c (i.e. 6.11%) 2. NIM= { RONW * NW/TA* 1/(1-t)} + NIE/TA = {0.3 * 0.1 * 1 / (1-0.6)} + 0.02 = 0.095 i.e. 9.5% 3. NIM= { RONW * NW/TA * 1/(1-t)} + NIE/TA 0.095= { RONW * 0.04 * 1/(1-0.6)} + 0.02 0.095 = (RONW* 0.1) + 0.02 0.095 - 0.02 = ( RONW * 0.01) 0.075/0.01= RONW 0.75 =RONW i.e 75%

7. RESULT : When Capital Adequacy  from 10% to 4%: RONW  from30% to 75% Financial Leverage (TA / NW) is  from 1/10% =10 time to 1/ 4%= 25 time When FI  Financial leverage its RONW  In good economic times, when revenue , high Fin leverage   RONW In bad economies when revenue , high Financial Leverage causes  in RONW How to  Financial Leverage ?  (TA/NW) i.e NW Multiplier ratio  (TL/ TA) i.e Debt Ratio  (TL / NW) i.e Debt Equity Ratio to  TA /NW, you can  NW by : issuing shares to raise fresh equity, or increasing NI and therefore RE, or by only decreasing dividends and thus increasing RE without increasing NI. A FIs’ financial leverage should be adjusted according to the economic conditions in the country, and should be such that it does not violate minimum capital adequacy requirements. In Recession: it is sensible to have  Leverage and in Boom  Leverage; but ability to correctly predict recession or boom for the next year is self questionable; please note that not many economist were correct in 2007 in predicting the ensuing recession of 2008-2009. However, apart from economic conditions other variables have to be considered as well. A bank can  TL by decreasing the deposits  by  i-rates on deposits and thus discouraging depositors, or by  minimum balance requirement of depositors, again to discourage depositors.

8. EXERCISE A FI institution has c of 7% and r of 11%. It is operating at minimum capital adequacy of 4%. Tax rate is 50%. Its NIE / TA ratio is 3%. REQUIRED: 1.TL/TA ratio 2.NIM it can earn 3.RONW it can earn 4.If this bank has a target of 25% for its RONW then what NIM should it earn? 5.To achieve 5% NIM, what yield on assets this bank should earn? 6.What was the required %age change in NIM to achieve target RONW of 25% 7.Increasing NIM 16.82% caused what %age change in RONW 8. To achieve 16.82% increase in NIM, you needed to make what %age change in yield on assets ( r )?

9. 1) NW /TA is given 4%. TA = TL + NW. TA / TA = TL / TA + NW /TA 1 = TL /TA + 0.04. TL /TA = 0.96 2) NIM = r - c * TL/TA. = 11% - 7%*0.96. =11% - 6.72%. = 4.28% 3) NIM = [ RONW * NW / TA * 1 / ( 1 – T)] + NIE /TA 4.28% = [RONW * 4% * 1 / (1 -0.5)] + 3%. 4.28% = [RONW * 4% * 2] + 3% 4.28% = [RONW *8%] + 3% 4.28% - 3% = RONW * 8% 1.28% / 8% = RONW 0.16 = RONW = 16% Solution

10. 4) NIM = [RONW * NW / TA * 1 / (1 – T)] + NIE / TA = [0.25 * 0.04 * 1 / (1 –0.5)] + 0.03 = [ 0.02] + 0.03 = 0.05 = 5% 5) NIM = r – c* TL / TA 0.05 = r - 0.07 * 0.96 0.05 = r - 0.0672 0.05 + 0.0672 = r = r = 11.72% 6) (0.05 – 0.0428) / 0.0428 = 16.82% 7) ( 25% - 16%) / 16% = 56.25% 8)(11.72% - 11%) / 11% = 6.54% NOTE: A 6.54% increase in r caused 16.82% increase in NIM, and 16.82% increase in NIM caused 56.25% increase in RONW. This is a prove that FIs are highly leveraged businesses, and minor improvements on revenue earning side have magnified impact on return for owners; the same is true for cost cutting, a slight decrease in cost of funds would have magnified impact on RONW. Solution