1️⃣ Featured Insight - Asset Liability Management & Reporting
Managing liquidity risk is one of the most critical aspects of running a financial institution. Banks and Non-Banking Financial Companies (NBFCs) are required to comply with stringent guidelines to ensure their liquidity position remains stable. In India, NBFCs with an asset size of more than ₹100 crore must adhere to regulatory norms for liquidity risk management to safeguard against potential financial instability.
💡Understanding Liquidity Risk in Financial Institutions
The core business model of financial institutions revolves around borrowing money from lenders (such as depositors, banks, or bond markets) and lending that money to their own customers at a higher interest rate. While this generates profits, it also exposes financial institutions to liquidity risks.
Liquidity risk refers to the possibility that a financial institution might not have enough cash or liquid assets to meet its short-term financial obligations, including loan repayments to creditors, operational expenses, and withdrawal requests from depositors.
A common liquidity challenge faced by NBFCs and banks is asset-liability mismatch. Many financial institutions borrow funds for short durations, such as 1 to 2 years, but lend them out for longer periods, such as 5 to 10 years. This creates a risk where the institution needs to repay its obligations before receiving repayments from its own borrowers, potentially leading to cash flow gaps and financial distress.
💡ALM Reporting
To effectively manage liquidity risk, financial institutions must maintain structured asset-liability ledgers. ALM reporting involves classifying both inflows (loan repayments from customers) and outflows (loan repayments to lenders) into different time buckets based on their tenure.
For every loan disbursed, financial institutions must determine when it is expected to be repaid and classify it into appropriate buckets based on tenor.
Similarly, all loans borrowed by the financial institution must be categorized based on their repayment schedule.
To ensure liquidity stability, financial institutions should ideally have more inflows than outflows in the short-term buckets, particularly in the next one-month and up-to-one-year tenors. However, in longer tenors, mismatches may arise due to extended loan durations.
Beyond individual time buckets, cumulative mismatches must be monitored to assess the overall liquidity health of the financial institution. A significant mismatch in near-term buckets can indicate potential liquidity distress and the need for corrective actions.
💡How to Classify Inflows in ALM Reporting?
The classification of cash inflows is crucial in ALM reporting, as it helps determine liquidity availability in different time frames. The key principles for classifying inflows include:
1. Standard Loan Accounts (Non-NPA Loans)
If a loan is standard (i.e., performing well) and has no overdue payments, its principal repayment is bucketed based on the original repayment schedule.
If the loan has an overdue of less than one month, it is classified into the 3 to 6-month bucket and subsequent buckets.
If the loan is overdue for up to 3 months, the entire outstanding amount is placed in the 1 to 3-year bucket and further buckets.
2. Non-Performing Assets (NPA) Loans
NPA loans require careful classification to avoid overestimating inflows:
The provision-adjusted principal amount can be considered as an inflow.
Any amounts due (including current overdues) within the next three years should be placed in the 3 to 5-year bucket.
Amounts due beyond three years must be placed in the over 5-year bucket.
3. Doubtful and Loss Accounts
Loans classified as doubtful or loss-making should be placed entirely in the over 5-year bucket, as recoverability is uncertain.
Liquidity risk management is essential for ensuring the financial stability of banks and NBFCs. By following a structured ALM framework and regulatory guidelines, financial institutions can proactively manage cash flow mismatches, maintain healthy liquidity, and prevent financial distress. Regulatory compliance, strategic borrowing, and prudent loan structuring play a crucial role in safeguarding financial institutions against liquidity risks.
Financial institutions must continually monitor liquidity gaps, implement corrective measures, and align their lending and borrowing strategies to maintain financial health and sustainability in the long run.
2️⃣ Industry News Roundup
🗓️ RBI imposes ₹76.6 lakh fine on four P2P NBFCs after their audit. [Reference]
🗓️ IndusInd Bank’s net worth took a hit of 2.35% over discrepancies found in accounting of their derivatives portfolio. [Reference]
3️⃣ Stats of the week
📊Overall Credit disbursement to Priority Sectors Jumps 85% from ₹23 Lakh Crores in 2019 to ₹42.7 Lakh Crores in 2024 [Reference]
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