Page 195 - DCOM304_INDIAN_FINANCIAL_SYSTEM

Indian Financial System

Notes and loan demand. Liability management has replaced asset management as a method to fund
liquidity needs. The effect of replacement of asset management by liability management would
be enhancement of credit risk since liquid asset have been replaced by loans. The replacement of
short-term assets by long-term assets would also require an increase in gross rates of return,
since upward sloping yield curves require higher rate of return on long-term assets than on
short-term assets.

Notes Asset liquidity is a reserve that a bank can fall back upon when bank's access to
funds is reduced. Liquid assets can also be used to fund loans when interest rates are
relatively high. Short-term assets are a less expensive source of funds than relatively high
interest rate deposits.

Foreign Exchange Risk

Foreign exchange risk arises out of the fluctuations in value of assets, liabilities, income or
expenditure when unanticipated changes in exchange rates occur. An open foreign exchange
position implies a foreign exchange risk. When a bank owns an uncovered claim in foreign
currency, it is said to be long and when it has uncovered liability in foreign currency, it is said
to be short. There are several techniques available to hedge or cover exposure to foreign exchange
risk. These techniques help in minimize the impact of unfavourable potential outcomes. Forward
contracts, money market alternative, foreign currency futures, currency swaps and foreign
currency options are used to cover exposure to foreign exchange risk.

Treasury Functions

To take advantage of the opportunities provided by development of new financial markets and
the internationalization of banking while managing risk has led to the growth of treasury
function within bank. The role of new treasury department is to manage a wide range of short-
term assets and liabilities. The dealers employed in treasury department are constantly trading
in wholesale deposits, interbank deposits, certificates of deposit, foreign exchange, repurchase
agreements, securities, financial futures and options. Apart from trading in short-term assets
and liabilities, the treasury department monitors the banks position with respect to earnings
and risks due to maturity gaps and interest rate or foreign currency exposures. The treasury
department usually reports to a high level treasury or asset and liability management committee.
The committee after taking into account the entire balance sheet of the bank as well as off-
balance sheet liabilities decides the treasury policy.

Monitoring Risks

To monitor risks, various techniques such as maturity profile, rate of interest ladder and concept
of duration have been developed. A maturity profile shows all assets and all liabilities by
maturities to enable the calculation of mismatches within each period. Rate-of-interest ladder
classifies all asset and liabilities by repricing dates and allows the calculation of rate of interest
risk for each period. Duration presents the interest exposure.

9.7 Asset and Liability Management

Asset and liability management is not a static technique but a dynamic approach to deal with the
problem banks face and changes in bank's goals. Frozen lending was offset by increasing
flexibility by making new loans against the provision of tradable assets which could be sold

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