Treasury and ALM

Treasury and ALM:
ALM refers to risk management to avoid mismanagement between Assets and Liabilities. The
risk of Liquidity and Interest rates, if not controlled may result into negative spread and can
cause loss to bank. Therefore ALM manages two risks : 1. Liquidity Risk & 2. Interest Rate Risk.
Liquidity Risk and Interest Rate Risk
We borrow from Money market and invest in 5 year G-securities. If Bond prices come down, we
are not willing to sell the bond, but loan has to be repaid. This may lead to shortage of funds
which is called Liquidity Risk.
Liquidity Risk is translated into Interest Rate Risk when funds have to be arranged at higher
rate. Mismatch between Assets and Liabilities also lead to Interest Rate Risk.
Role of ALM to mitigate Liquidity Risk
Liquidity Gap arises when there is difference between souses and uses of funds. RBI has
prescribed Time bands to measure Liquidity Gaps. These are
1-14 days.
14-29 days
1M – 3M
ALM measures the gap between Uses and Sources between above said Time bands.
RBI has also prescribed limits of maximum negative mismatch as under:
Next Day -------5%
2-7 Days------10%
8-14 Days—-15%
15-28 Days--20%
ALM takes steps to meet shortfall as a contingent measure at a reasonable rate.
Interest rate Gap leads to erosion of NII (Net Interest Income) due to difference between
earnings and payments.
ALM has the following role to play:
 Treasury establishes a link between Core banking and market operations to manage
risks.
 Treasury earns profits by managing funds out of mismatches.
 Treasury hedges residual risk in Forex market.
 Treasury monitors exchange rates and interest rate movements in the market.
Use of Derivatives in ALM
Derivatives are used to hedge high value individual transactions.
For Example: Medium Term Loan of 3 Years is funded by Deposit of 3M because 3M deposit is
cheaper and NII is increased.
 Bank may swap 3M interest rate into fixed rate into Fixed rate for 3 years.Bank may also
swap Fixed interest rate on loan into floating rate linked to T-bill rate. If 3M deposit rate
is T+1% and 3Year interest rate on loan is T+3%, there will be NII@2%.

 Bank may arbitrage Forex. It can buy USD funds at cheaper rate (say 3%) and invest in
rupee loan at 6.5%. The spread can be 3.5%
Risks of Derivatives: Derivatives are not free from risks. Tworisks involved in Derivatives are:
1. Residual risk i.e. basis risk.
2. Embedded Option Risk :There are embedded options in certain bank products. E.g. FD
is paid premature or TL is pre-paid. It affects the ALM policy if pre-mature payments are
large.
Treasury and Credit Risk
There are chances of failure on the part of counter party to meet its obligations especially when
Treasury deals in:
1. Debt Market products such as CPs, Bonds, Debentures etc.
2. Securitization of Credit Receivables – when credit receivables are converted into Units
or Bonds which are called PTCs ( Pass-through certificate).
3. SPV –Special Purpose Vehicle enables the banks to securitize the Mortgage loans
Credit Derivatives
1. Credit Default Swaps
2. Total Returns Swap
3. Credit Linked Notes
Transfer Pricing
It is important function of ALM. It relates to:
 Fixing cost of recourses and return on Assets.
 ALM notionally buys and sells deposits and loans of the bank.
 Price is paid for buying deposits and price is received for selling loans. This is called
Transfer Pricing.
 The prices vary according to the tenure or maturity of deposits and loans.
 Deposits are bought by Treasury at a rate arrived at by adjusting hedging cost from rate
of deposit. If bank accepts deposits%7% and cost of hedging is 1%, the deposits will be
bought by Treasury @6%.
 Loans are sold to Treasury at transfer cost. For example, 10% loan may be notionally
sold to Treasury @7%. The balance is denoted as Risk premium.
 Treasury Division, after implementing the Transfer Pricing takes care of Liquidity Risk
and Interest rate risk.