Asset-Liability Management

Module: 1 - Business is a Trade off between Risk & Reward
[By Ms. Sailashree, PG Student, IIT, Roorke]

Preface
External Environment, is the Source Both of Opportunities & Threats to
Business Organizations

We all know that the environment external to a business organisation not only provides immense opportunities, but also exposes it to constant threats. By way of example-

Opportunities
The external environmental analysis may reveal certain new opportunities for profit and growth. Some examples of such opportunities include

• Increasing demand for the products manufactured by us

• New designs and technology developed by the corporate unit

• Loosening of regulations

• Removal of international trade

Threats
Changes in the external environmental also may present threats to the firm. Some examples of such threats include:

• Shifts in consumer tastes away from the firm's products

• Emergence of substitute products

• New regulations

• Increased trade barriers

Opportunities and threats emanating from the external setting are beyond the scope of the organisation to control or influence. It can however appropriately respond with proper measures to avail the benefit or avert the consequences as the case may be of the two. The implementing tool for this purpose is through strategic planning. Strategic planning is the process of developing and maintaining a strategic fit between the organization's goals and capabilities and its changing environment and opportunities. It involves defining a clear company mission, setting supporting objectives, designing a sound business portfolio, and coordinating functional strategies. The process of achieving goals (reaping opportunities) include the actions that are needed to cross the road blocks and overcome the obstructions on the path (risk mitigation)

Opportunities and threats are generalized terms referred universally covering all organizations. But when we consider a particular organisation or particular category of organisations, it is possible to define and distinguish with greater detail and identify the kind of opportunities and threats with definite precision and description. At this stage we term opportunities as "rewards" and threats as "risks". The organisation pursues all efforts towards securing identified rewards and alleviating the familiar risks that are encountered in the process.

Rewards here represent the objectives set by the organisation for achievement as enunciated in its Vision and Mission Statements. Seeking rewards is a continuous process and as part of its performance planning, the organisation sets sectoral goals for achievement. Rewards may be towards tangible gains or even intangible benefits. Some of the rewards that a corporate body may aspire to achieve taking recourse to the opportunities opening to it in the business environment are-

• Maximisation of profits or of shareholders� wealth;

• Increasing customer capital, i.e. strengthening the base of customer loyalty for the products of the business;

• Developing the human resources of the organisation, i.e. increase in human capital;

• Developing the structured capital or intellectual properties of the organization etc.

Simply speaking, a risk is any uncertainty about a future event that threatens the organization's ability to accomplish its mission. Business is a trade off between risk and return. There can be no risk-free or zero risk-oriented business. This is due to the fact that the concept of business operations implies effecting current investment, for a continuous activity stretching to the future, and looking for a future gain. Changes in the intervening period can be either ways. When such changes are adverse, the investment in the business may come to grief or may face adverse results.

Some influences are external to the firm. These cannot be controlled. But they affect the business with wider impact. Other influences are internal to the firm and are controllable. Risks that are external and broad in their effect are called sources of systematic risk. Conversely, controllable, internal factors somewhat peculiar to industries and/or firms are referred to as sources of unsystematic risk.

Systematic risk refers to that portion of total variability in return caused by the factors affecting the prices of the products marketed by the organisation. Economic, political and sociological changes are sources of systematic risk. Their effect is to cause all market prices to move together in the same manner.

Unsystematic ris is the portion of total risk that is unique to a firm or industry. Factors such as management capability, consumer preferences, and labor strikes cause systematic variability of returns in a firm. Unsystematic factors are largely independent of factors affecting particular organisations to which they relate.

The various types of systematic risks are as follows:

• Market Risk: it is caused by customer reaction to tangible as well as intangible events. It is the variability in returns on most common products that is due to basic sweeping changes in buyer expectations.

• Interest-Rate Risk: it refers to the uncertainty of future market values and of the size of future income, caused by fluctuations in the general level of interest rates.

• Purchasing Power Risk: it is the uncertainty of the purchasing power of the amounts to be received. It refers to the impact of inflation or deflation on an investment.

The various types of unsystematic risk are as follows:

• Business Risk: it is a function of the operating conditions faced by a firm and the variability these conditions inject into operating income and expected dividends.

• Financial Risk: it is associated with the way in a company finances its activities. It is an avoidable risk to the extent that managements have the freedom to decide to borrow or not borrow funds. A firm with no debt financing has no financial risk.

Traditionally it is believed that if a business organization has a favourable current ratio, it will not have short-terms debt-servicing or problems relating to meeting its other liabilities. Similarly if it has the benefit of a positive Debt-Equity Ratio and generates adequate profitability it should have no problem of meeting its long-term obligations of debt repayment & other such payment obligations. But this is not so.

The company�s current ratio may be favourable and it may have enough current assets to meet all its accruing liabilities. But these current assets may be blocked in the shape of slow moving or non-moving assets like overdue receivables or piled up inventory. Unless the floating assets quickly rotate and generate adequate cash in-flow, the company despite holding sufficient current assets would face liquidity problem to discharge its payment obligations in time.

Similarly despite a positive Debt-Equity Ratio and adequate profitability being generated, the Company may not be in a position to discharge its obligations of payment of interest and installment, unless it is able to generate adequate cash in flow, controlling inventory holding and arresting overdue receivables.

Such mismatches between cash in-flow and cash outflow have come to be termed as Asset Liability Risk or Asset Liability Mismatch. We will cover about this in greater detail in this project.

Since 1992, significant changes have been introduced in the Indian financial system. These changes have infused an element of competition in the financial system, marking the gradual end of State directed economy characterised by price and non-price controls in the process of financial intermediation.

While financial markets have been fairly developed, there still remains a large extent of segmentation of markets and non-level playing field among participants. This leads to volatility in asset prices. This volatility is aggravated by the lack of liquidity in the secondary markets. The situation exposes elements of risks in the financial system.

Risk is inherent in the very act of financial transformation. However, prior to reform of 1991-92, financial institutions were not exposed to diverse financial risks mainly because interest rates were regulated, financial asset prices moved within a narrow band and the roles of different categories of intermediaries were clearly defined. Credit risk was the major risk for which FIs adopted certain appraisal standards. But after 1991 sweeping changes resulted on account of the impact of the all round reforms in the Indian economy.

Several structural changes have taken place in the financial sector since 1992. The operating environment has undergone a vast change bringing to fore the critical importance of managing a whole range of financial risks. The key elements contributing to this transformation are-

• The deregulation of coupon rate on Government securities,

• Substantial liberalisation of bank deposit and lending rates,

• A gradual trend towards disintermediation in the financial system in the wake of increased access of corporates to capital markets,

• Blurring of distinction between activities of financial institutions,

• Greater integration among the various segments of financial markets and their increased order of globalisation, diversification of ownership of public sector banks and,

• Emergence of new private sector banks and other financial institutions, and,

• The rapid advancement of technology in the financial system

Thus, risks to financial markets in India have arisen mainly out of the process of deregulation of interest rates, disintermediation, integration of different segments of markets and initiation of globalisation process.

As the real sector reforms began in 1992, the need was felt to restructure the Indian banking industry. The reform measures necessitated the deregulation of the financial sector, particularly the banking sector. The initiation of the financial sector reforms brought about a paradigm shift in the banking industry. The Narasimham Committee Report on the banking sector reforms highlighted the weaknesses in the Indian banking system and suggested reform measures based on the Basle norms. The guidelines that were issued subsequently laid the foundation for the reformation of Indian banking sector. The deregulation of interest rates and the scope for diversified product profile gave the banks greater leeway in their operations. New products and new operating styles exposed the banks to newer and greater risks. Though the types of risks and their dimensions grew, there was not much being done by the banks to address the situation. At this point, the Reserve Bank of India, the chief regulator of the Indian banking industry, has donned upon itself the responsibility of initiating risk management practices by banks. Moving in this direction, the RBI announced the prudential norms relating to Income Recognition, Asset Classification and Provisioning and the Capital Adequacy norms, for the banks. These guidelines ensured that the Indian banks followed international standards in risk management.