Asset-Liability-Management FOR NBFC
Asset-Liability-Management FOR NBFC
Non-Banking Financial Companies (NBFC) are exposed to credit and market risks in
view of the asset-liability transformation. With liberalisation in Indian financial markets
over the last few years and growing integration of domestic markets with external
markets and entry of multinational companies for meeting the credit needs of not only
the corporate but also the retail segments, the risks associated with NBFCs' operations
have become complex and large, requiring strategic management.
NBFCs are now operating in a fairly deregulated environment and are required to
determine on their own, interest rates on deposits, subject to the ceiling of maximum
rate of interest on deposits they can offer on deposits prescribed by the Bank; and
advances on a dynamic basis. The interest rates on investments of NBFCs in
government and other securities are also market related. Intense competition for
business involving both the assets and liabilities has brought pressure on the
management of NBFCs to maintain a good balance among spreads, profitability and
long term viability. Imprudent liquidity management can put NBFCs' earnings and
reputation at great risk and these pressures call for structured and comprehensive
measures.
The managements of NBFCs have to base their business decisions on a dynamic and
integrated risk management system and process, driven by corporate strategy. NBFCs
are exposed to three major risks in the course of their business - credit risk, market risk
and operational risk. It is, therefore, important that NBFCs introduce effective risk
management systems that address the issues relating to market risks primarily interest
rate and liquidity risks.
NBFCs need to address these risks in a structured manner by upgrading their risk
management and adopting more comprehensive Asset-Liability Management (ALM)
practices. ALM provides a comprehensive and dynamic framework for measuring,
monitoring and managing liquidity and interest rate risks of the NBFCs that needs to be
closely integrated with the business strategy. It involves assessment of various types of
risks and altering the asset-liability portfolio in a dynamic way in order to manage risks.
The risk management process would require strong commitment on the part of
the senior management in the NBFC, to integrate basic operations and strategic
decision making with risk management. The Board should have overall
responsibility for management of risks and should decide the risk management
policy of the NBFC and set limits for liquidity and interest rate risks. There should
be an executive level Committee styled as Asset Liability Committee (ALCO) at
the top. For a Deposit Taking NBFC (NBFC-D) with asset size of Rs. 100 crores
and above or holding public deposits of Rs. 20 crores and above, there is also a
need to additionally constitute a Board level Risk Management Committee as per
Corporate Governance Guidelines issued by RBI.
The ALM Support Groups consisting of operating staff should be responsible for
analysing, monitoring and reporting the risk profiles to the ALCO. The staff
should also prepare forecasts (simulations) showing the effects of various
possible changes in market conditions related to the balance sheet and
recommend the action needed to adhere to NBFC's internal limits.
Measuring and managing liquidity needs are vital for effective operation of
NBFCs. By ensuring an NBFC's ability to meet its liabilities as they become due,
liquidity management can reduce the probability of an adverse situation
developing. The importance of liquidity transcends individual institutions, as
liquidity shortfall in one institution can have repercussions on the entire system.
NBFCs management should measure not only the liquidity positions of NBFCs
on an ongoing basis but also examine how liquidity requirements are likely to
evolve under different assumptions. Experience shows that assets commonly
considered as liquid, like Government securities and other money market
instruments, could also become illiquid when the market and players are
unidirectional. Therefore, liquidity has to be tracked through maturity or cash flow
mismatches. For measuring and managing net funding requirements, the use of
a maturity ladder and calculation of cumulative surplus or deficit of funds at
selected maturity dates is adopted as a standard tool.
The Maturity Profile should be used for measuring the future cash flows of
NBFCs in different time buckets. The time buckets, may be distributed as 1 day
to 30/31 days (One month), over one month and up to 2 months, over two
months and up to 3 months, over 3 months and up to 6 months, over 6 months
and up to 1 year, over 1 year and up to 3 years, over 3 years and up to 5 years
and over 5 years.
Alternatively, the NBFCs can also follow the concept of Trading Book wherein the
composition and volume are clearly defined, maximum maturity/duration of the
portfolio is restricted, the holding period not to exceed 90 days, cut-loss limit
prescribed and defeasance periods (product-wise) are prescribed.
NBFCs which maintain such ‘Trading Books’ and are complying with the above
standards should show the trading securities under "1 day to 30/31 days (One
month)", Over one month and up to 2 months" and "Over two months and up to 3
months" buckets on the basis of the defeasance periods. The Board/ALCO of the
NBFCs should approve the volume, composition, holding/defeasance period, cut
loss, etc. of the ‘Trading Book'. The remaining investments should also be
classified as short term and long term investments as required under Prudential
Norms.
Within each time bucket, there could be mismatches depending on cash inflows
and outflows. While the mismatches up to one year would be relevant since
these provide early warning signals of impending liquidity problems, the main
focus should be on the short-term mismatches viz., 1-30/31 days. NBFCs,
however, are expected to monitor their cumulative mismatches across all time
buckets by establishing internal prudential limits with the approval of the Board /
Management Committee.
The mismatches (negative gap) during 1-30/31 days in normal course may
not exceed 15% of the cash outflows in this time bucket.
The NBFCs monitor their short-term liquidity on a dynamic basis over a time
horizon spanning from 1 day to 6 months by estimating their short-term liquidity
profiles on the basis of business projections and other commitments for planning
purposes.
Interest rate risk is the risk where changes in market interest rates might
adversely affect an NBFC's financial condition. The immediate impact of changes
in interest rates is on NBFC's earnings (i.e. reported profits) by changing its Net
Interest Income (NII). A long-term impact of changing interest rates is on NBFC's
Market Value of Equity (MVE) or Net Worth as the economic value of NBFC's
assets, liabilities and off-balance sheet positions get affected due to variation in
market interest rates. The interest rate risk when viewed from these two
perspectives is known as ‘earnings perspective’ and ‘economic value
perspective', respectively. The risk from the earnings perspective can be
measured as changes in the Net Interest Income (NII) or Net Interest Margin
(NIM).
The Gap or Mismatch risk can be measured by calculating Gaps over different
time intervals as at a given date. Gap analysis measures mismatches between
rate sensitive liabilities and rate sensitive assets (including off-balance sheet
positions). An asset or liability is normally classified as rate sensitive if:
The Gap Report should be generated by grouping rate sensitive liabilities, assets
and off-balance sheet positions into time buckets according to residual maturity
or next repricing period, whichever is earlier. All investments, advances,
deposits, borrowings, purchased funds, etc. that mature/reprice within a specified
timeframe are interest rate sensitive. Similarly, any principal repayment of loan is
also rate sensitive if the NBFC expects to receive it within the time horizon. This
includes final principal payment and interim instalments. Certain assets and
liabilities, having a linkage to reference rate, receive/pay rates. These assets and
liabilities are repriced at pre-determined intervals and are rate sensitive at the
time of repricing.
The Gaps may be identified and slotted into various time buckets. The time
buckets, may be distributed as 1 day to 30/31 days (One month), over one month
and up to 2 months, over two months and up to 3 months, over 3 months and up
to 6 months, over 6 months and up to 1 year, over 1 year and up to 3 years, over
3 years and up to 5 years, over 5 years and non-sensitive.
The Gap is the difference between Rate Sensitive Assets (RSA) and Rate
Sensitive Liabilities (RSL) for each time bucket. The positive Gap indicates that it
has more RSAs than RSLs whereas the negative Gap indicates that it has more
RSLs than RLAs. The Gap reports indicate whether the institution is in a position
to benefit from rising interest rates by having a positive Gap (RSA > RSL) or
whether it is in a position to benefit from declining interest rates by a negative
Gap (RSL > RSA). The Gap can, therefore, be used as a measure of interest rate
sensitivity.
Each NBFC should set prudential limits on individual Gaps with the approval of
the Board/Management Committee. The prudential limits should have a
relationship with the Total Assets, Earning Assets or Equity. The NBFCs may
work out Earnings at Risk (EaR) or Net Interest Margin (NIM) based on their
views on interest rate movements and fix a prudent level with the approval of the
Board/Management Committee.
Filing of Returns: