Asset Liability Management (Liquidity Risk and Interest Rate Risk in Banking Book (IRRBB)) in the bank - Why does it matter more today than ever

Asset-Liability Mismatch

The mismatch in the difference in timing at which the bank accepts deposits and provides loans creates an asset-liability mismatch within the bank\'s Treasury, which serves as the main hub for managing the bank\'s funds. To explain this we can take a simple example where the bank has accepted the deposit of Rs. 100 for 1 year from the customer and lent it for 3 years to the borrower. While the borrower would repay the debt after 3 years, a bank would be obligated to return the funds to the depositor after one year.

In real life, there would be many deposits (of various tenors ranging from one week to 10 years) that the bank would be receiving from the customers and many advances that the bank would be lending to its customers. So, the Treasury department plays a critical role in managing the liquidity position of the bank.

What is Liquidity Risk and why it is important for banks?

Liquidity risk is the potential risk that a bank may be unable to meet its funding obligations without incurring huge losses such as by selling assets at greatly reduced price. Liquidity risk is a very peculiar risk applicable to the banking industry because of the nature of the business explained above (borrowing from depositors and lending to customers). Liquidity risk can threaten the very existence of the bank.

Banks are considered to be trustworthy organizations that will not default on their obligations. Imagine a situation where a bank has failed to repay its due amount. Public trust in that bank and in the banking industry as a whole will be eroded and when that happens, imagine what would happen to the economy?

Bank Run and perception of the public

Treasurer\'s worst nightmare is the BankRun. Bank Run means all depositors flocking at the same time in front of the bank/ ATM to withdraw their money. This can be due to some rumors or due to some adverse news about the bank in the market which has shaken public confidence in the bank. So, as a preventive control, top management should always display good governance and sound management/ accounting practices which maintain the good reputation of the bank.

Consider, for example, the confidence that people feel when depositing their money with a Public Sector Bank (PSB) compared to private sector bank. PSBs are backed by the government and will rarely fail but private sector banks are more prone to failures due to management issues or risk of fraud by key managerial personnel. Hence, even though private sector banks have better infrastructure and IT capabilities compared to PSBs, PSBs garner more deposits and have around 60% of the total outstanding deposits compared to 40% held by private sector/ foreign banks. I am not talking here about the pros and cons of PSBs or private sector banks but giving a perspective that maintaining public confidence is the key to preventing bankruns.

RBI regulations on Liquidity Risk

Given the importance of liquidity to the banks, RBI from time to time has issued various guidelines for the banks. Let\'s go through them one-by-one.

CRR and SLR

Most of the general public is aware of the concept of Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR). CRR requires banks to hold a specific percentage (currently 4.50%) of their Net Demand and Time Liabilities (NDTL) as cash with the Reserve Bank of India (RBI). SLR requires banks to maintain a specified portion (currently 18%) of their Net Demand and Time Liabilities (NDTL) in liquid assets, primarily in government securities (G-Secs). This is not pledged/maintained with RBI but held by the banks in it books of account as investment.

STL and IRS

A Statement of Structural Liquidity (STL) is a statement that gives details of the liquidity position of the bank in different buckets. It is a tool for measuring and controlling liquidity risk. It plots the expected funds inflow and outflow in different buckets (such as one day, 2-7 days, 8-14 days, 15-30 days, and so on). At the end of the calculation, bucket-wise funds mismatch is calculated by subtracting fund outflow from funds inflow. For example, the bank has to repay term deposits of Rs. 107 to its customer in the next one week and it is supposed to receive Rs. 110 from its borrower. Then this will reflect as a net positive figure of Rs. 3 (Rs. 110- Rs. 107) in the 2-7 days bucket. RBI has set certain restrictions on the net cumulative mismatches in each of the buckets to control the asset-liability mismatch.

Interest Rate Sensitivity (IRS) statement gives details of rate-sensitive assets and rate-sensitive liabilities in different buckets. It is a tool for measuring and controlling interest rate risk. All the interest rate-sensitive assets and liabilities are plotted in different buckets according to maturity date or next repricing date, whichever is earlier. For example, in the case of floating rate bonds which are repriced (i.e. interest rate fixed) every six months, its next repricing date will be considered, instead of its maturity date for bucketing. IRS gives details of the sensitivity of the changes in interest rate to the bank\'s earnings and net worth.

Stress testing

RBI has given scenarios, assumptions, and run-off factors to be considered by the banks while performing the stress testing. It is a way to assess the preparedness of the bank in case of an adverse event that impacts the bank or banking industry as a whole. It assumes accelerated outflows and conservative inflows in times of stress. This is done assuming a stress period of 30 days. If the inflows are more than the outflows after applying the RBI assumptions and run-off factors, it is said that the bank can withstand the stress. In case it doesn\'t, the bank has to prepare a plan of action and list down the sources of funds through which it will finance and meet its obligation during stressful times. This is done through the Contingency Funding Plan (CFP).

LCR and NSFR

This is latest of all the guidelines which has come out of BASEL regulations after the 2008 financial crisis. Liquidity Coverage Ratio (LCR) is a ratio that tells how much High- Quality Liquidity Asset (HQLA) a bank holds corresponding to its 30-day net cash outflow (under stress scenario).

In other words, HQLA is nothing but liquid securities (G-Sec and corporate bonds (haircut is applied on corporate bonds) that can be sold to pay the bank\'s obligations arising in the next 30-day under a stress scenario. As per the current regulations, this ratio is 100%.

Net Stable Funding Ratio (NSFR) is a ratio that ensures that a bank has funded its assets through stable funds. Stable funds are funds which are stable in nature and are less volatile. For example, term deposits from retail customers are less volatile compared to deposits from corporate customers. Funding through stable sources reduces the cost of funds to the banks and does not create liquidity issues. Take it this way, suppose the bank has financed loans and advances through unstable funds, it may lead to a situation wherein the bank may have to repay the borrowing whereas it cannot ask the borrowers to repay its loans and advances before maturity thereby leading to the liquidity crisis.

LCR, from 2014, has become the single most important ratio for liquidity risk management in bank Treasury across the globe. The calculation of LCR is complex and has attracted the attention of the regulators during their annual inspection. Regulators including RBI are in the process of revising certain parameters/run-off factors (percentage of outflow to be considered e.g. 10% of the corporate deposits assumed to be withdrawn in times of stress) due to the advent in technology and the ability of the depositors to quickly transfer the funds from one bank to another. This will impact the banking system due to the need to maintain more HQLA and reduce their profitability due to lower earnings on HQLA.

Liquidity Risk Monitoring Tools

• Contractual maturity mismatch
• Funding concentration
• Available unencumbered assets
• LCR by significant currency
• Market related monitoring tools

Out of the above, funding concentration is important since it assesses the concentration of funding by a few counterparties which may pose a risk in case they were to shift their relationship to another bank or stop providing funding in the future.

Daily cash flow projections

Cash inflows, outflows, and end-of-day balance are projected. This is done for both INR and foreign currencies. There should be sufficient balance available in the RBI account at day-end to take care of RTGS / NEFT payments (since it is available 24x7 and 365 days a year) and maintain CRR as per the RBI requirements. Similarly, projections are done for day-end balance in foreign currencies to ensure that there is no negative balance in the nostro account (account maintained by an Indian bank with a foreign bank in a foreign country) and resultant penalty by the nostro bank. These projections are dynamic in nature and typically done several times in a day to account for inflows and outflows coming in during business hours.

Asset Liability Management Committee (ALCO)

ALCO is one of the important committees that each bank has and is responsible for managing the bank\'s assets and liabilities. ALCO usually consists of the MD & CEO of the bank, Treasury Head, Head Asset and liability management (ALM), CRO, and other business heads depending on the committee charter. Asset Liability issues and liquidity issues are discussed in ALCO, and the committee draws up an action plan. The ratios and liquidity statements as described above are presented and discussed in the meeting.

Current Liquidity situation - High Credit to Deposit ratio (CD ratio)

CD ratio is a key metric in Treasury asset liability management and has been in the news lately. CD ratio is a ratio of loans and advances given to the customers to the deposits mobilized from customers. In other words, how much percentage of deposits has been deployed in loans and advances? The ideal CD ratio is between 75-80%.

Post COVID-19, there is a spike in credit demand from the industry due to an overall rise in business activity. Deposit has not kept pace with the credit demand (one of the reasons is people prefer to invest in capital markets and mutual funds rather than keep their money in savings accounts or term deposits) and hence, there is a gap between credit and deposit growth. A High level of CD ratio is not considered good since it indicates that the bank is funding all its incremental loans and advances through incremental deposits (which includes borrowings through certificate of deposits) or through external borrowings (in the worst case). If deposit flow slows down, the bank\'s ability to grant loans and advances will be jeopardized. Also, the cost of funds will increase (since banks will have to offer a higher rate of interest on deposits to generate additional deposits) and the bank\'s net interest income will reduce.

Further, there is liquidity risk in lending through external borrowings such as interbank borrowing as it gives rise to systemic risk in the sense that the failure of one bank can impact the liquidity position of other banks. Hence, it is very important that bank attract depositors by giving them confidence about the strong governance and management of the bank to sustain credit growth and maintain a healthy NIM and liquidity position.

Usually, Treasury department is the one who decides rate of interest on deposits and has to consider the CD ratio and other liquidity/ market factors while publishing the rate of interest on deposits.

Interest Rate Risk in Banking Book (IRRBB)

In Bank Treasury, there are primarily two books: the Trading Book and the Banking Book. The Trading Book includes assets that Treasury trades to generate profits, such as equities, corporate bonds, and forex. The Banking Book encompasses all assets not held in the Trading Book. Interest rate risk is the potential for adverse movements in interest rates, which can result in losses for the bank. For instance, if the bank holds a bond yielding an 8% coupon while the market interest rate is 7%, the bond will trade at a premium (above Rs. 100). If the interest rate rises by 1% to 8% over the next six months, the bond\'s price will fall because its coupon remains at 8%.

IRRBB, rather an important aspect in Treasury Asset Liability Management was long ignored but has gained limelight after the failure of Silicon Valley Bank in 2023.

Quick recap on the failure of SVB

During COVID-19, businesses had to temporarily halt their operations, and they had cash with them which they wanted to keep safe (the stock market was not in good condition and bank deposits are considered safe). This flushed the banks with so much deposits/ liquidity (credit offtake was low due to near zero business activity) that banks decided to invest them in safe heaven Government bonds/ US T-Bills. Banks classified them in the held-till-maturity (HTM) category or at amortized cost since they intended to hold them till maturity. As per the accounting guidelines, Mark-to-Market (MTM) valuation is not done for securities held in the HTM book.

The interest rate at that time was nearly 0%. Things changed rapidly post COVID and economic activities were happening like never before. This fuelled inflation and central banks across the globe raised the interest rates. Federal Reserve in the US raised interest from 0% to 5% in one year\'s time. Since the price of bonds and interest rate are inversely related, banks had heavy MTM losses in their HTM books. Due to heavy losses, there was news about capital raising by the bank and depositors started to lose confidence in the bank and decided to withdraw the money. There was run-on the bank and the bank went bankrupt since it did not have sufficient liquid assets to pay the depositors. Luckily, the US government stepped in and guaranteed the depositor\'s money.

Due to the run on SVB Bank, there was a contagion effect and run on other banks such as First Republic Bank and Signature Bank which also collapsed in 2023.

Why IRRBB Is Important?

As explained above, the Treasury has to maintain SLR and now LCR, and most of these are invested in liquid government securities in the HTM portfolio (banking book) since banks do not intend to gain from trading in these securities. With the rise in interest rate in 2023, there has been huge MTM losses in this book. This got hidden in the books of accounts since the investments were carried at amortized cost and there was no mark-to-market of these securities. But with the collapse of SVB Bank, regulators got acting fast and swiftly.

RBI guidelines on IRRBB

IRRBB has an impact on 2 things, changes in the economic value of equity (EVE) and earnings. Changes in the economic value of equity mean an impact on the net worth of the bank due to interest rate shocks. Changes in earnings mean impact on net interest income of the bank due to interest rate shocks. Banks need to fix limits on both these items and senior management should review the exposure on a regular basis.

Banks need to apply interest rate shocks prescribed by RBI, decided internally by the bank, or any other scenario to assess the impact on both EVE and earnings.

Further, banks are required to undertake stress testing on IRRBB and take its results into consideration while making strategic decisions.

Post the above, banks should assess whether they need to raise more capital based on the impact on net worth and future earnings potential. RBI has set a threshold of a 15% decline in Tier I capital for the banks to start acting, i.e. reducing IRRBB exposure, managing the risk (i.e. hedging), or raising additional capital. Accurate and timely MIS reporting to senior management is important to assess the situation and take appropriate actions. However, since we are at the peak of the interest rate cycle, further impact on IRRBB will be limited in the near future.

Conclusion

In a nutshell, there are 7 things that matter the most today in Treasury Asset and Liability of the Bank.

1. Confidence of the depositors: Senior management should provide confidence to the depositors that their money is safe through the display of good governance and ethical practices.
2. LCR: Managing LCR has become the utmost important thing. Various interpretations and supervisory comments keep the Treasury busy in managing this ratio.
3. Funding concentration: Managing funding concentration from a single counterparty or say top 20 counterparties is critical to avoid funding reliance on a few counterparties.
4. Daily funding management and CD ratio: Managing day-to-day funding has become difficult and banks are in a deposit-mobilization war to keep their CD ratio in check.
5. IRRBB: Although there is no immediate need for Indian Banks to worry about IRRBB, they need to continuously monitor the limit utlization and take necessary action, if required.
6. Internal Capital Adequacy Assessment Process (ICAAP): Banks must assess their capital needs in light of liquidity and interest rate risks, among other factors.
7. Effective ALM requires a comprehensive approach that integrates liquidity management, interest rate risk management, and capital planning to ensure that the bank remains solvent and profitable under various conditions.