Factors Affecting Effective Management Of Asset Liability In Commercial Banking: A Case Of Equity Bank.
SUBMITTED IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE FINAL YEAR RESEARCH PROJECT OF THE BACHELOR OF COMMERCE DEGREE KCA UNIVERSITY
JUNE 2013
CHAPTER ONE
INTRODUCTION
1.0 INRTODUCTION
The research proposal focuses on establishing the factors affecting effective management of Asset Liability in commercial banking with special reference to Equity Bank. This chapter entails the background of the study, statement of the problem, research objectives, and research questions, justification of the study, significance of the study as well as the scope of the study.
1.1 Background of the Study
Asset Liability Management (ALM) is a critical function to the banks and financial institutions in present environment due to volatile global market, proliferation of new financial products and changing environment of regulatory system (Harrington, 2007). It is a dynamic and comprehensive framework that helps banks and financial institutions to measure, monitor and manage the market risk. Under this system, structure of balance sheet is managed in proper way to ensure that the net earnings from interest are maximized and risks are minimized. The ALM system has various functions to manage risks such as liquidity risk management, market risk management, trading risk management, funding and capital planning, profit planning and growth projection (Eng, 2008). It enables the banks to take business decisions in a more informed framework through considering risks. It is an integrated approach that covers both types of amounts financial assets and liabilities with the complexities of the financial market.
The banking sector still remains an important index of entrepreneurship and economic development in Kenya. The Central Bank of Kenya is given the responsibility to provide a lot of attention to harmonization of legislation regulating banking sector, to its compliance to the Kenya Banking Control directives. New regulations for capital sufficiency calculations have been approved allowing for assessing market risk taken by commercial banks and determining the need for additional capital (Crosse & George, 2000). Commercial banks focus their activities on the aim of profit maximization at the same time trying to remain liquid and ensuring security. This study is aimed at investigating how Asset liability management can be performed best in commercial banks where Equity Bank has been used to represent other commercial banks in Kenya.
Asset Liability Management (ALM) plays a critical role in weaving together the different business lines in a financial institution. Managing liquidity and the balance sheet are crucial to the existence of a financial institution and sustenance of its operations. It is also essential for seamless growth of the balance sheet in a profitable way. Currently, even large multinational financial institutions are in a deep liquidity crisis and in direct need of external intervention for survival (Bierwag, 2002). The practical importance of ALM and Liquidity Management has been somewhat underestimated. Even managements of large institutions, regulators, and observers saw how well reputed firms and trusted institutions folded up and were not able to find a way out of the deep liquidity crisis. This resulted in regulators attaching high importance to new measures needed to ensure a sound liquidity management system.
Consequently, regulators have enhanced and in some geographies, thoroughly serviced, regulatory oversight on ALM and liquidity management.
1.2 Statement of the Problem
Over the last few years, the Commercial Banking sector in Kenya has continued to grow in assets, deposits, profitability and products offering. The growth in the banking sector has experienced a boost through the provision of Asset Liability to its customers (Kannan, 1996). However, commercial banks have experienced a big challenge in managing asset liability that can cause huge losses for the businesses. To begin with, there has been a problem in commercial banks to meet governments’ policy standards on the management of asset liability. Managers do not take the responsibility to take good control of Asset liability in commercial banks.
It is a big challenge for commercial banks to disclose all their income to the government for tax purposes whereby, by disclosing they will pay taxes hence making little profits (Sinkey, 1992). In commercial banks, the market can be so small to provide asset liability which may take too long to be repaid. The banks may find themselves making losses by customers not meeting their loan demands to the banks. This is a big challenge that requires commercial banks to substitute the available funds to the unpaid liabilities. Many commercial banks have problems in managing Structural Gaps which must be critically and continuously monitored. This imposes a risk to the management of asset liability whereby gaps that must be realized and settled are not able to be established. Managing Interest Rate Sensitivity has also been a challenge to ALM managers (Flannery, 2006).
Hence this study is aimed at investigation of the factors affecting effective management of asset liability in commercial banks with special Equity Bank, Kenya.
1.3 Research Objectives
1.3.1 General Objective
The main aim of the study is to establish the factors affecting the management of Asset Liability in commercial banks with special reference to Equity Bank.
1.3.2 Specific Objectives
i. To establish the effect of Government Policy on the management of Asset Liability in commercial banking.
ii. To find out the effect of Interest Rate Sensitivity on the management of Asset Liability in commercial banking.
iii. To determine the effect of structural gaps on the management of Asset Liability in commercial banking.
1.4 Research Questions
i. To what extent does government policy affect the management of Asset Liability in commercial banking?
ii. To what extent does Interest Rate Sensitivity affect the management of Asset Liability in commercial banking?
iii. To what extent do structural gaps affect the management of Asset Liability in commercial banking?
1.5 Justification of the Study
In present scenario, ALM is important for the banking industry due to deregulation of interest regime. It helps to assess the risks and manage the risks by taking appropriate actions. For the purpose of understanding the ALM process and various strategies that are helpful for the banks to manage the market risk, the researcher seeks to investigate asset liability management practices that can be used in commercial banks. In the past studies, most of the authors widely analyze the problems of asset and liability management in their research works. However, much focus is on individual problems of commercial banks performance such as balancing profitability and risk, or portfolio optimization problems. Opinions are generalized to emphasize on harmonization of performance in commercial banks while striving to balance profitability, liquidity and security. In this study, the factors that affect effectiveness in the management of asset liability in commercial banks are areas that authors have not dealt with. This study therefore, takes the initiative to take into account and analyze asset and liability management practices for the achievement of growth in commercial banks.
1.6 Significance of the Study
1. The Management in Equity Bank
This study discusses the factors affecting the effectiveness of asset liability management in commercial banks. The research shall be of great importance to the management in Equity Bank since it advances knowledge and understanding of the key asset liability management practices that improves the performance of the organization.
This research shall also help the management to put in place or strengthen their existing practices in the management of asset liability to improve financial performance in their organizations.
2. Management in Commercial Banks
Managers in other commercial banks will benefit from this study since information provided here is not restricted to be used by only Equity bank managers. Managers and in other commercial banks within the country can use the information provided in this study to manage the asset liability as well as other financial management requirements that enable a firm to operate profitably. This will help in enabling the achievement of more competitive and better performing commercial banks in Kenya.
3. Other Researchers
Future researchers shall be able to use the information in this study to find out more on the factors affecting the effectiveness in the management of asset liability in commercial banks in Kenya and other countries. By developing this study, researchers will provide information that helps in developing the good management of asset liability for commercial banks.
1.7 Scope of the Study
The study is aimed at investigating the factors affecting the effectiveness of asset liability management in commercial banks in Kenya. The research will take Equity Bank to represent other commercial banks within the country and to expound on the role of asset liability management practices on the performance of commercial banks. The study will target all employees working at equity bank head office totaling to 185 in number. The research investigates various asset liability practices that commercial banks must use to enable good financial performance of their businesses. Some of the factors that are discussed in this study Government Policy, market interest sensitivity as well as structural gaps.
CHAPTER TWO
LITERATURE REVIEW
2.1 Introduction
The researcher will use a variety of available books and the internet to describe past studies done by different scholars on matters concerning the factors affecting the effective management of asset liability management in commercial banks. The researcher expounds specifically on how government policy, interest rate sensitivity as well as structural gaps affects the effective management of asset liability management in commercial banks.
2.2 Review of Theoretical Literature
2.2.1 Government Policy
Commercial banks have been recommended to adopt an asset liability management policy (ALM policy) that will enable them addresses limits on the maximum size of major asset liability categories, pricing loans and deposits, correlating maturities and terms, controlling interest rate risk and establishing interest rate risk measurement techniques, controlling foreign currency risk, controlling the use of derivatives, requiring management analysis and expert consultation for derivative transactions, frequency and content for board reporting (Jain, 1996). The purpose of adopting an ALM policy by commercial banks will assist the credit union to manage risk and to comply with the Standards in the policy. When complying with the ALM policy, it must not conflict with requirements prescribed by the Act and Regulations, and any relevant interpretive bulletins or guidelines issued by the government body.
It is optimal for key regulatory requirements to be repeated in ALM policy, for greater user clarity and ease of reference. Section 78(1) of the Regulation 76/95 also requires commercial banks to establish ALM policies and procedures. When establishing ALM policies and procedures, management and the board should ensure they meet regulations requirements (Hampel, 1998). Over the last few years the Kenyan financial markets have witnessed wide ranging changes at fast pace. Intense competition for business involving both the assets and liabilities, together with increasing volatility in the domestic interest rates as well as foreign exchange rates, has brought pressure on the management of banks to maintain a good balance among spreads, profitability and long term viability. These pressures call for structured and comprehensive measures and not just ad hoc action.
Cates (2008) argues that, the Management of banks has to base their business decisions on a dynamic and integrated risk management system and process, driven by corporate strategy. Banks are exposed to several major risks in the course of their business; this include credit risk, interest rate risk, foreign exchange risk, equity / commodity price risk, liquidity risk and operational risks. It is evident that interest rate and liquidity risks in banks form part of the Asset-Liability Management (ALM) function. ALM organization involves structure and responsibilities as well as the level of top management involvement (Gup, 1997). The ALM process involves Risk parameters, Risk identification and Risk measurement, Risk management, Risk policies and tolerance levels. Information is the key to the ALM process.
Considering the large network of branches and the lack of an adequate system to collect information required for ALM which analyses information on the basis of residual maturity and behavioral pattern it will take time for banks in the present state to get the requisite information. The problem of ALM needs to be addressed by following an ABC approach, that is analyzing the behavior of asset and liability products in the top branches accounting for significant business and then making rational assumptions about the way in which assets and liabilities would behave in other branches (Kaufmann, 2004). In respect of foreign exchange, investment portfolio and money market operations, in view of the centralized nature of the functions, it would be much easier to collect reliable information. The data and assumptions can then be refined over time as the bank management gain experience of conducting business within an ALM framework. The spread of computerization will also help banks in accessing data.
Asset liability organization requires the board to have overall responsibility for management of risks and should decide the risk management policy of the bank and set limits for liquidity, interest rate, and foreign exchange and equity price risks. The Asset Liability Committee (ALCO) consisting of the bank’s senior management including CEO should be responsible for ensuring adherence to the limits set by the Board (Simonson & George, 2002). They are also responsible for deciding the business strategy of the bank on the assets and liabilities sides in line with the bank’s budget and decided risk management objectives. The ALM desk consisting of operating staff should be responsible for analyzing, monitoring and reporting the risk profiles to the ALCO.
The staff should also prepare forecasts or simulations showing the effects of various possible changes in market conditions related to the balance sheet and recommend the action needed to adhere to bank’s internal limits. The ALCO is a decision making unit responsible for balance sheet planning from risk return perspective including the strategic management of interest rate and liquidity risks (Murply, 2006). Each bank will have to decide on the role of its ALCO, its responsibility as also the decisions to be taken by it. The business and risk management strategy of the bank should ensure that the bank operates within the limits / parameters set by the Board. The business issues that an ALCO would consider, first, will include product pricing for both deposits and advances, desired maturity profile of the incremental assets and liabilities among others. In addition to monitoring the risk levels of the bank, the ALCO should review the results of and progress in implementation of the decisions made in the previous meetings. The ALCO would also articulate the current interest rate view of the bank and base its decisions for future business strategy on this view (Mishkm, 1995).
2.2.2 Interest Rate Sensitivity
In asset liability management, there is need to differentiate sensitive and non sensitive liabilities. Liabilities such as Capital, Reserves and Surplus, Current Deposits, Savings Bank Deposits Sensitive to the extent of interest paying are non sensitive liabilities. The non-interest paying portion may be shown in non-sensitive area. Term Deposits and Certificates of Deposit and re-prices on maturity are sensitive. The amounts should be distributed to different areas on the basis of remaining maturity (Yeager & Neil, 2009).
However, in case of floating term deposits, the amounts may be shown under the time area when deposits contractually become due for re-pricing. Liabilities such as borrowings are fixed Sensitive and re-prices on maturity. The amounts should be distributed to different areas on the basis of remaining maturity (Crosse & George, 2000). Borrowings are floating sensitive and re-prices when interest rate is reset. The amounts should be distributed to the appropriate bucket which refers to the repricing date. For borrowings that are Zero Coupon Sensitive and reprices on maturity. The amounts should be distributed to the respective maturity buckets. Regarding the level of interest rate risk acceptable to the bank the board should also approve policies that identify lines of authority and responsibility for managing interest rate risk exposures (Harrington, 2007). The board should get regular information about the interest rate risk exposure of the bank and periodically review the performance of senior management in monitoring and controlling these risks in compliance with the approved policies.
In addition, the board or one of its committees should periodically re-evaluate significant interest rate risk management policies as well as overall business strategies that affect the interest rate risk exposure of the bank. Senior management must ensure that the structure of the bank’s business and the level of interest rate risk it assumes are effectively managed, that appropriate policies and procedures are established to control and limit these risks on both a long-term and day-to-day basis, and that resources are available for evaluating and controlling interest rate risk (Sinkey, 1992). Asset Liability Management is also responsible for maintaining appropriate limits on risk taking, adequate systems and standards for measuring risk, standards for valuing positions and measuring performance, a comprehensive interest rate risk reporting and interest rate risk management review process as well as effective internal controls. Rate sensitive assets (RSA) are any loans or investments that can be repriced either up or down in interest rate within a given time frame (Bierwag, 2002). The following represent some examples of assets that would be considered rate sensitive: Federal Funds sold, Securities purchased under agreement to resell, All loans maturing within a given time frame, All securities maturing within a given time frame, Principal payments on all securities that are to be received using current prepayment, speed assumptions, Principal payments on all loans that are to be received including the impact of expected prepayments if deemed to be significant, All loans with floating interest rates, and when the floating rate can change with respect to caps and floors as well as the repricing characteristics of the underlying index, All securities with floating interest rates, and when the floating rate can change with respect to caps and floors as well as the repricing characteristics of the underlying index (Simonson & George, 2002).
Special attention shall be paid to any assets having embedded options like calls, prepayments, repricing, among others. For better management of asset liability, it is important to define lines of responsibility and accountability for both individuals and committees over interest rate risk management decisions (Kannan, 1996). There is need for defining authorized instruments, hedging strategies and position taking opportunities. Identifying quantitative parameters that define the level of interest rate risk acceptable for the bank, is also necessary for certain types of instruments, portfolios, and activities.
Ensure that there is adequate separation of duties in key elements of the risk management process to avoid potential conflicts of interest such as the development and enforcement of policies and procedures, the reporting of risks to senior management, and the conduct of back-office functions (Flannery, 2006). All interest rate risk policies should be reviewed periodically and revised as needed. The management should define the specific procedures and approvals necessary for exceptions to policies, limits and authorizations. Banks should identify the interest rate risks inherent in new products and activities and ensure these are subject to adequate procedures and controls before being introduced or undertaken. Major hedging or risk management initiatives should be approved in advance by the board or its appropriate delegated committee (Eng, 2008). Banks should have interest rate risk measurement systems that capture all material sources of interest rate risk including re-pricing; yield curve, basis and option risk exposures and that assess the effect of interest rate changes in ways that are consistent with the scope of their activities.
As noted by Hampel (1998), interest rate sensitive liabilities in each time band are subtracted from the corresponding interest rate sensitive assets to produce a repricing “gap” for that time band. This gap can be multiplied by an assumed change in interest rates to yield an approximation of the change in net interest income that would result from such an interest rate movement. The size of the interest rate movement used in the analysis can be based on a variety of factors, including historical experience, simulation of potential future interest rate movements, and the judgment of bank management. A negative, or liability-sensitive, gap occurs when liabilities exceed assets including off balance sheet positions in a given time band (Cates, 2008).
This means that an increase in market interest rates could cause a decline in net interest income. Conversely, a positive or asset-sensitive gap implies that the bank’s net interest income could decline as a result of a decrease in the level of interest rates.
2.2.3 Structural Gaps
In a commercial bank with a mature ALM function, this is arguably the most critically and continuously monitored aspect, since the ALM Managers seek to manage the structural gaps in the Balance Sheet. While liquidity management focuses typically on short-term time ladders, the structural gap management shifts the focus on time ladders more than a year (Kaufmann, 2004). This aspect of ALM stresses the importance of balancing maturities as well as cash flows on either side of balance sheet. It strategizes dynamically on balancing the gaps, issuing timely guidelines to adjust focus on ‘right’ product types and tenors, and actively involve ALCO in this process. In a static gap the ALM function takes into consideration assets maturing in short, medium and long time ladders and seeks to balance it in comparison with liabilities maturing across short, medium and long term ladders.
The gaps reports typically point to funding gaps and excess funds at different points in time. The challenge with the ALM function is that the gaps are dynamically evolving and need continuous monitoring as the balance sheet changes every day. Duration is considered as a measure of interest rate sensitivity (Jain, 1996). Macaulay’s duration is traditionally accepted as a good measure of ‘length’ of portfolio or a measure of center of gravity of discounted cash-flows over life of an asset (or liability).
It’s common practice to measure duration of portfolio for different product types as well as on an overall portfolio level. It’s useful to simulate how duration of portfolio will be affected by future events. For a dynamic gap it is normal practice to rely on dynamic gap reports to simulate future gap positions for assumed business volumes and exercise of options such as prepayments. In addition to proposed new volumes, prepayment transactions and assumed deposit roll-overs, the ALM manager would like to include a proposed hedge transaction (Murply, 2006). ALM practitioners prefer to focus on the ratio of assets and liabilities exceeding one year and often want to set acceptable limits around this. Where there are operative limits, the ALCO meetings will usually monitor the ratio, and the institution constantly endeavors. Asset liability management in commercial banks is improved by controlling and maintaining structural gaps that may be experienced.
To manage these gaps commercial banks gap and interest rate exposure is compiled and reviewed on a separate basis. The GAP reports will be used to measure risk to net interest income arising from the repricing of assets and liabilities over time. Funds gap or gap is positive when the peso amount of sensitive assets exceeds that of sensitive liabilities. The gap is negative if sensitive liabilities exceed sensitive assets (Yeager & Neil, 2009). When sensitive assets are equal to sensitive liabilities, there is a zero fund gap. With a positive gap, the interest margin would increase if short-term rates rose and decrease if short-term interest rates fell. With a negative gap, the interest margin would decline if short-term rates rose and increase if short-term rates fell.
If there is zero gap, interest margin will be stable or will not change regardless of the rise or fall of short-term rates. The first strategy is to accept fluctuation in interest margin and do nothing about it. The second strategy is to manage the funds gap over the rate cycle. If management expects a fall in short-term interest rate and there is a positive gap, it should widen the gap or increase rate sensitive assets (Mishkm, 1998). If management expects a rise in short-term interest rate and there is a negative gap, it should narrow the gap or increase rate sensitive assets. The third strategy is for the bank management is to decide not to take interest rate risk by seeking a zero gap position. The fourth strategy is for the management to use artificial hedges where financial futures to cover the loss that might result from the rise or fall of short term interest rate. When short term interest rises, Zero fund gap or perfect match and positive gap or where more rate sensitive assets (RSA) are financed by Fixed Rate Liabilities (FRL) (Cates, 2008).
For a negative gap or where more Fixed Rate Assets (FRA) exists, they are financed by Rate Sensitive Liabilities (RSL). The interest margin performance of individual banks varies during such cyclical periods. These differences in interest margin performance appear to be explained primarily by endogenous factors such as the nature of the bank’s assets and liabilities and the reaction of the bank to expected exogenous factors (Sinkey, 1992). In the typical funds gap management system, management is asked to classify all items in each side of the bank’s balance sheet into groups of items whose cash flows are sensitive and those whose cash flows are insensitive to changes in short term interest rates.
Thus, an asset or liability is identified as sensitive if cash flows from the asset liability change in the same direction and general magnitude as the change in short-term rates. The cash flows of insensitive or non sensitive assets liabilities do not change within the relevant time period. Funds gap is negative if sensitive liabilities exceed sensitive assets (Bierwag, 2002). When sensitive assets are equal to sensitive liabilities, there is a zero fund gap. With a positive gap, the interest margin would increase if short-term rates rose and decrease if short-term rates fell. With a negative gap, the interest margin would decline if short-term rates rose and increase if short-term rates fell. If there is zero gap, interest margin will be stable or will not change regardless of the movement of short-term rates. If management expects interest rates to fall and there is a positive gap, it should widen the funds gap or increase rate-sensitive assets. On the other hand, management should narrow the banks funds gap or increase rate sensitive assets if interest rates are expected to rise and there is a negative gap. If used effectively, such gap management decisions should lead to higher returns.
According to Harrington (2007), commercial banks that follow a positive strategy in asset liability management should pay considerably more attention to comparative weight of the volume of assets with flexible interest rate than to equilibrium of liabilities with flexible interest rate. Positive gap is understood as situation when the share of income-earning assets with fixed interest rate will be less than the share of liabilities with fixed interest rate in total volume of interest generating liabilities of the bank. As the result, bank total returns received on the credits will decrease (Kannan, 1996).
However, because of existing positive gap between assets and liabilities the total income of the bank will be subject to changes to larger extent than costs. The bank’s profit decreases correspondingly. If along with the drop of interest rate in the market the present value of assets increases, the present value of liabilities with fixed interest rate also increases. Although the bank follows the positive strategy in asset and liability management, net return of the bank decreases.
2.3 Review of Critical Literature
The ALM core function consists of managing maturity gaps and mismatches while managing interest rate risk within the overall mandate prescribed by ALCO. This study did not provide any information on the core action that the asset liability management must take to ensure good management of asset liability. A financial institution typically relies on certain measures to evaluate and manage interest rate sensitivities. This research did not focus on how to deal with Interest Rate Sensitivity Gap Reports where the ALM function seeks to monitor interest rate sensitivity by generating so-called interest rate sensitive gap reports. The research did not discuss the function of interest rate gap reports which provide a cash flow laddering based on re-pricing profile and frequency of interest rate sensitive assets and liabilities. Commercial banks attach much importance to assessing the impact of interest rate changes, new business, change in product-mix and roll-over of deposits on net interest income. Income statements that allow for comparison of net interest income under different scenarios are immensely helpful in understanding the impact of mild market movements and shocks on the income statement as well as balance sheet.
The study has not established the ALM functions whether it seeks to generate daily gaps on short-term ladders and ensures that cumulative gaps operate within pre-set limits.
2.4 Summary
This study has established the building blocks of an ALM solution from all perspectives while observing those aspects that the institution must address functionally as part of their ALM solution. Proper asset and liability management allows for achievement of banking harmony in the bank’s performance. This means that the balance in combining its striving for maximization of the profit at the same time ensuring its liquidity with the least risk. Whatever strategy is used in managing asset liability in commercial banks in its performance, it shows that it is able to follow contemporary systemic approach in asset and liability management, what has direct impact not only on the bank’s performance, but also the profit.
2.5 Conceptual Framework
Independent V
