Efficient asset-liability management (ALM) requires a robust, integrated risk management system. Every financial activity in banks that poses major risks, such as credit, market, and even operational risk, converges into it, triggering liquidity risk – surplus or deficit. Even if ALM mismatches stem from the balance sheet’s composition, managing ALM ultimately involves either deploying surplus funds or borrowing to cover shortfalls through tactful cost-risk balancing. The cost of managing liquidity risks is a function of the financial market that ultimately affects banks’ profitability.  

The state of ALM is the pooling of information about assets and liabilities at a particular point in time, reflecting the distribution of their residual maturities across the RBI-prescribed ten core time buckets known as the structural liquidity framework. Every financial transaction that originates must terminate at some point through liquidity, either by receiving funds or paying them. 

ALM is a function of planned management of the balance sheet.  The result of the vision, mission, and corporate objectives pursued by a bank over a medium to long time span. As balance sheets differ across banks, the structural liquidity pattern embedded in ALM also differs. Hence, at any given time, one bank borrows while the other one deploys, fuelling the money market and determining interest rates.  

ALM, a critical cost-sensitive liquidity risk management function, is closely regulated to ensure financial stability and the sustainability of the financial system. In addition to LCR/NSFR norms, ALM management is closely regulated by the RBI through risk-based supervision (RBS), in which banking activities are scrutinized through a risk-sensitivity lens. RBI prescribes several regulations to ensure that credit, market, and operational risks are contained within the risk appetite of regulated entities.

ALM has always been a focused function for banks and regulated entities, but it becomes more critical when the gap between credit and deposit growth widens, forcing banks to aggressively tap the liquidity market. When too many entities compete for the same liquidity, costs rise, impacting not only profitability but also, in rare instances, the likelihood of banking institutions collapsing. The classic case of ALM’s serious implications is reflected in the collapse of Silicon Valley Bank (SVB) in the US in 2023. 

The present ALM structure of any regulated entity is the result of many years of balance sheet management. ALM is not a siloed activity. It reflects years of work by the entity, carried out in conformity with its internal policies and priorities within the regulatory framework. Any adverse ALM position having wide liquidity gaps cannot be corrected instantly. It needs a long-term, transformative vision, a diversified product range, and pricing strategies well aligned with market trends. The immediate remedy is either to borrow funds to meet structural liquidity gaps or to deploy excess funds to manage liquidity risks at market-driven interest rates. 

Temporary liquidity gaps are known as frictional liquidity gaps. Banks can meet their funding needs through various money market instruments. They can explore the call money market, where the weighted average call rate (WACR) is now quoted at 5.37 percent (as of June 24), or access funds through CCIL’s Tripartite repo window at close to repo rate.  The RBI’s Liquidity Adjustment Facility (LAF) is available for borrowing through the repo route, and the Marginal Standing Facility (MSF) can be used to borrow up to 2% of NDTL against SLR securities at a 25-basis-point higher interest rate than the repo rate. If these windows are not sufficient, banks draw funds through Certificates of Deposit (CDs), with interest rates ranging from 5.78 percent for 14 days to 7.7 percent for up to 1 year, depending on the tenor.  

RBI keeps track of systemic liquidity and conducts variable rate repo (VRR) auctions to pump liquidity if liquidity is in short supply or sucks liquidity by conducting Variable rate reverse repo (VRRR) auctions. It enables banks to bid for funds or place funds at market rates, which are usually higher than the repo or reverse repo rate. RBI monitors WACR to assess systemic liquidity conditions, focusing on the interest rate corridor between the SDF rate (5%) and the MSF rate (5.50%). If the WACR is below 5 percent, liquidity is perceived as in excess; if it exceeds 5.50 %, liquidity is said to be in short supply. RBI activates VRR/VRRR tools if the adverse liquidity conditions persist.

Normally, deposit growth exceeds credit growth, providing banks with a continuous supply of lendable resources. In recent years, due to shifting savings preferences among bank customers, deposit growth has slowed, more noticeably over the last 3 years, bringing ALM risks into focus. 

The development of mutual funds and alternative investment options is driving some depositors away. The number of demat accounts increased from 11.4 crores to 22.5 crores, and the assets under management (AUM) of mutual funds increased from Rs. 39.4 trillion in March 2023 to Rs. 81.5 trillion by May 2026. Even the direct participation of individual investors in the equity market has also increased. 

Higher credit growth at 15.4%, 16.4%, 11.4%, and 14.5% during FY23-26, and slower deposit growth at 9.6%, 13.5%, 11.1%, and 12.7% during the corresponding period intensified liquidity risks. 

During FY27, up to May 31, credit grew by 17.65% and deposits by 12.21%, widening the gap to 550 basis points, with the credit-to-deposit CD ratio reaching 82.75%. Such wide ALM gaps led to higher liquidity risks and a surge in money market interest rates, which could compress banks’ net interest margins (NIMs).

While banks must use money market tools to manage frictional liquidity gaps, they must plan effectively to adopt better-aligned strategies and business models that steadily increase deposit inflows within the desired time bucket and narrow ALM gaps. A granular study of ALM data, mapping it to customers’ age profiles and changing preferences, will be required. 

A customer survey to map customer needs for better product planning, digital penetration, and customer centricity, and to explore the distribution network through digital touchpoints and business correspondents, will need to be developed. Management of ALM risks is not confined to meeting liquidity gaps in the market; it is about ensuring that such gaps are, as far as possible, closed through systematic business transformation to reduce liquidity risk. 

A structural shift in the balance sheet is needed through the deliberate mobilization of business, comprising assets and liabilities of the desired tenor, to generate sustainable structural liquidity, optimize the cost-income ratio, and protect NIM and EPS. The use of forecasting techniques, simulation, scenario building, and stress testing of ALM, with reference to the projected balance sheet mix, is necessary. Therefore, managing ALM risks requires a deep dive into the root causes of gaps while meeting immediate needs by exploring the money market. 

END OF ARTICLE