Risks have a negative effect on a bank’s future earnings, savings and on the market value of its fairness because of the changes in interest rates. Handling assets invites different types of risks. Risks cannot be avoided or neglected in bank management. The bank has to analyze the type of risk and necessary steps need to be taken. With respect to assets, risks can further be categorized into the following −
Floating exchange rate arrangement has brought in its wake pronounced volatility adding a new dimension to the risk profile of banks’ balance sheets. The increased capital flows across free economies following deregulation have contributed to an increase in the volume of transactions.
Large cross-border flows together with the volatility has rendered the banks’ balance sheets vulnerable to exchange rate movements.
It 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.
Banks undertake operations in foreign exchange like accepting deposits, 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. 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. Ever since the RBI (Exchange Control Department) introduced the concept of end of the day near square position in 1978, banks have been setting up overnight limits and selectively undertaking active daytime trading.
The phased deregulation of interest rates and the operational flexibility given to banks in pricing most of the assets and liabilities have exposed the banking system to Interest Rate Risk.
Interest rate risk is the risk where changes in market interest rates might adversely affect a bank’s financial condition. Changes in interest rates affect both the current earnings (earnings perspective) as also the net worth of the bank (economic value perspective). The risk from the earnings’ perspective can be measured as changes in the Net Interest Income (Nil) or Net Interest Margin (NIM).
Therefore, ALM is a regular process and an everyday affair. This needs to be handled carefully and preventive steps need to be taken to lighten the issues related to it. It may lead to irreparable harm to the banks on regards of liquidity, profitability and solvency, if not controlled properly.