There was no significant interest rate risk during the 1970s to early 1990s period. This is because the interest rates were formulated and recommended by the RBI. The spreads between deposits and lending rates were very wide.
In those days, banks didn’t handle the balance sheets by themselves. The main reason behind this was, the balance sheets were managed through prescriptions of the regulatory authority and the government. Banks were given a lot of space and freedom to handle their balance sheets with the deregulation of interest rates. So, it was important to launch ALM guidelines so that banks can remain safe from big losses due to wide ALM mismatches.
The Reserve Bank of India announced its first set of ALM Guidelines in February 1999. These guidelines were effective from 1st April, 1999. These guidelines enclosed, inter alia, interest rate risk and liquidity risk measurement, broadcasting layout and prudential limits. Gap statements were necessary to be made by scheduling all assets and liabilities according to the stated or anticipated re-pricing date or maturity date.
At this stage the assets and liabilities were enforced to be divided into the following 8 maturity buckets −
On the basis of the remaining intervals to their maturity which are also referred as residual maturity, all the liability records were to be studied as outflows while the asset records were to be studied as inflows.
As a measure of liquidity management, banks were enforced to control their cumulative mismatches beyond all time buckets in their statement of structural liquidity by building internal prudential limits with the consent of their boards/ management committees.
According to the prescribed guidelines, in the normal course, the mismatches also known as the negative gap in the time buckets of 1-14 days and 15-28 days were not to cross 20 per cent of the cash outflows with respect to the time buckets.
Later, the RBI made it compulsory for banks to form ALCO, that is, the Asset Liability Committee as a Committee of the Board of Directors to track, control, monitor and report ALM.
This was in September 2007, in response to the international exercises and to satisfy the requirement for a sharper evaluation of the efficacy of liquidity management and with a view to supplying a stimulus for improvement of the term-money market.
The RBI fine-tuned these regulations and it was ensured that the banks shall accept a more granular strategy for the measurement of liquidity risk by dividing the first time bucket that is of 1-14 days currently in the Statement of Structural Liquidity into three time buckets. They are 1 day addressed next day, 2-7 days and 8-14 days. Hence, banks were demanded to put their maturing asset and liabilities in 10 time buckets.
According to the RBI guidelines announced in October 2007, banks were recommended that the total cumulative negative mismatches during the next day, 2-7 days, 8-14 days and 15-28 days should not cross 5%, 10%, 15% and 20% of the cumulative outflows, respectively, in order to address the cumulative effect on liquidity.
Banks were also recommended to attempt dynamic liquidity management and design the statement of structural liquidity on a regular basis. In the absence of a fully networked environment, banks were permitted to assemble the statement on best present data coverage originally but were advised to make careful attempts to attain 100 per cent data coverage in a timely manner.
In the same manner, the statement of structural liquidity was to be presented to the RBI at regular intervals of one month, as on the third Wednesday of every month. The frequency of supervisory reporting on the structural liquidity status was changed to fortnightly, with effect from April 1, 2008. The banks are expected to acknowledge the statement of structural liquidity as on the first and third Wednesday of every month to the Reserve Bank.
Boards of the Banks were allocated with the complete duty of the management of risks and were needed to conclude the risk management policy and set limits for liquidity, interest rates, foreign exchange and equity price risks.
The Asset-Liability Committee (ALCO) is one of the top most committees to overlook the execution of ALM system. This committee is led by the CMD/ED. ALCO also acknowledges product pricing for the deposits as well as the advances. The expected maturity profile of the incremental assets and liabilities along with controlling, monitoring the risk levels of the bank. It needs to mandate the current interest rates view of the bank and base its decisions for future business strategy on this view.
The ALM process rests on the following three pillars −
It comprises of functions like identifying the risk parameters, identifying the risk, risk measurement and Risk management and laying out of Risk policies and tolerance levels.
The key to the ALM process is information. The large network of branches and the unavailability an adequate system to collect information necessary for ALM, which examines information on the basis of residual maturity and behavioral pattern makes it time-consuming for the banks in the current state to procure the necessary information.
Measuring and handling liquidity requirements are important practices of commercial banks. By persuading a bank’s ability to satisfy its liabilities as they become due, the liquidity management can minimize the probability of an adverse situation developing.
Liquidity go beyond individual foundations, as liquidity shortfall in one foundation can have backlash on the complete system. Bank management should not only portion the liquidity designations of banks on an ongoing basis but also analyze how liquidity demands are likely to evolve under crisis scenarios.
Past experience displays that assets commonly assumed as liquid like Government securities and other money market tools could also become illiquid when the market and players are Unidirectional. Thus liquidity has to be chased through maturity or cash flow mismatches.