Draft Guidelines on Securitization of Standard Assets

Guidelines for Asset Liability Management System in Housing Finance Companies

In the normal course, Housing Finance Companies (HFCs) are exposed to credit and market risks in view of the asset-liability transformation. With liberalisation in Indian financial markets over the last few years and growing integration of the domestic markets with external markets, the risks associated with the operations of an HFC have become complex and large, requiring strategic management. HFCs are operating in a fairly deregulated environment and are required to determine on their own, interest rates on advances and deposits, subject to the ceiling on maximum rate of interest they can offer on deposits, on a dynamic basis. The interest rates on investments of HFCs in government and other securities are also now market related. Intense competition for business involving both the assets and liabilities has brought pressure on the managements of HFCs to maintain a good balance amongst spreads, profitability and long-term viability. These pressures call for structured and comprehensive measures and not just ad hoc action. The managements of HFCs have to base their business decisions on a dynamic and integrated risk management system and process driven by corporate strategy. HFCs are exposed to several major risks in the course of their business – credit risk, interest rate risk, equity/commodity price risk, liquidity risk and operational risk. It is, therefore, important that HFCs introduce effective risk management systems that address the issues relating to interest rate and liquidity risks.

2. HFCs need to address these risks in a structured manner by upgrading their risk management and adopting more comprehensive Asset-Liability Management (ALM) practices than has been done hitherto. ALM, among other functions, is also concerned with management of risks and provides a comprehensive and dynamic framework for measuring, monitoring and managing liquidity and interest rate risks of an HFC that need to be closely integrated with the HFC’s business strategy. It involves assessment of various types of risks and altering the asset-liability portfolio in a dynamic way in order to manage risks.

3. This note lays down broad guidelines for HFCs in respect of systems for management of liquidity and interest rate risks which forms part of the ALM function. The initial focus of the ALM function would be to enforce the discipline of market risk management viz. managing business after assessing the market risks involved. The objective of a good risk management system should be to evolve into a strategic tool for effective management of HFCs.

4. The ALM process rests on three pillars:
. ALM Information System
» Management Information Systems
» Information availability, accuracy, adequacy and expediency
. ALM Organisation
» Structure and responsibilities
» Level of top management involvement
. ALM Process
» Risk parameters
» Risk identification
» Risk measurement
» Risk management
» Risk policies and tolerance levels

ALM Information Systems
5.1 ALM has to be supported by a management philosophy that clearly specifies the risk policies and tolerance limits. This framework needs to be built on sound methodology with necessary supporting information system as the central element of the entire ALM exercise is the availability of adequate and accurate information with expedience. Thus, information is the key to the ALM process. There are various methods prevalent world-wide for measuring risks. These range from the simple Gap Statement to extremely sophisticated and data intensive Risk Adjusted Profitability Measurement methods. The systems existing in some of the major HFCs do not generate information in the manner required for ALM. Collecting accurate data in a timely manner will be the biggest challenge before the HFCs, particularly those lacking full-scale x. However, the introduction of base information system for risk measurement and monitoring has to be addressed urgently.

5.2 HFCs have heterogeneous organisational structures, capital base, asset sizes, management profile, and geographical spr-9ead. Some of them have large number of branches and agents/brokers whereas some have unitary offices. Considering the present network of branches and the lack of (an adequate) support system to collect information required for ALM which analyses information on the basis of residual maturity and re-pricing pattern of liabilities and assets, it will take time for HFCs in the present state to get the requisite information. In respect of investment portfolio and funds management, in view of the centralised 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 HFC management gain experience of conducting business within an ALM framework. The spread of computerisation will also help HFCs in accessing data.

ALM Organisation
6.1 a) Successful implementation of the risk management process would require strong commitment on the part of the senior management in the HFC, to integrate basic operations and strategic decision making with risk management. The Board should have overall responsibility for management of risks and should decide the risk management policy of the HFC and set limits for liquidity, interest rate, exchange rate and equity price risks.
b) The Asset-Liability Committee (ALCO) consisting of the HFC’s senior management including the Chief Executive Officer (CEO) should be responsible for ensuring adherence to the limits set by the Board as well as for deciding the business strategy of the HFC (on the assets and liabilities sides) in line with the HFC’s budget and decided risk management objectives.
c) The ALM Support Groups consisting of operating staff should be responsible for analysing, monitoring and reporting the risk profiles to the ALCO. The staff should also prepare forecasts (simulations) reflecting the impact of various possible changes in market conditions on the balance sheet and recommend the action needed to adhere to HFC’s internal limits.

6.2 The ALCO is a decision-making unit responsible for integrated balance sheet management from risk-return perspective including the strategic management of interest rate and liquidity risks. Each HFC will have to decide on the role of its ALCO, its powers and responsibilities as also the decisions to be taken by it. The business and the risk management strategy of the HFC should ensure that it operates within the limits/parameters set by the Board. The business issues that an ALCO would consider will, inter alia, include product pricing for both deposits and advances, desired maturity profile and mix of the incremental assets and liabilities, prevailing interest rates offered by other peer HFCs for similar services/product, etc. In addition to monitoring the risk levels of the HFC, 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 HFC and base its decisions for future business strategy on this. In respect of the funding policy, for instance, its responsibility would be to decide on the source and mix of liabilities or sale of assets. Towards this end, it will have to develop a view on future direction of interest rate movements and decide on funding mixes between fixed vs. floating rate funds, wholesale vs. retail funds, money market vs. capital market funding , domestic vs. foreign currency funding, etc. Individual HFCs will have to decide the frequency of holding their ALCO meeting.

Composition of ALCO
6.3 The size (number of members) of ALCO would depend on the size of each institution, business mix and organisational complexity. To ensure commitment of the Top Management and timely response to market dynamics, the CEO/CMD/President or the ED should head the Committee. The Chiefs of Investment, Credit, Resources Management or Planning, Funds Management/ Treasury, International Business and Economic Research can be members of the Committee. In addition, the Head of the Technology Division should also be an invitee for building up of MIS and related computerisation. Large HFCs may even have Sub-committees and Support Groups.

Committee of Directors
6.4 The Management Committee of the Board or any other Specific Committee constituted by the Board should oversee the implementation of the ALM system and review its functioning periodically.

ALM Process
7. The scope of ALM function can be described as under:
. Liquidity risk management
. Management of market risks
. Funding and capital planning
. Profit planning and growth projection
. Forecasting and analysing ‘what if scenario’ and preparation of contingency plans

The guidelines contained in this note mainly address Liquidity and Interest Rate risks.

Liquidity Risk Management
8.1 Measuring and managing liquidity needs are vital for effective operation of HFCs. By assuring an HFC’s ability to meet its liabilities as they become due, liquidity management can reduce the probability of an adverse situation developing. The importance of liquidity transcends individual institutions, as liquidity shortfall in one institution can have repercussions on the entire system. HFCs’ management should measure not only the liquidity positions of HFCs on an ongoing basis but also examine how liquidity requirements are likely to evolve under different assumptions. Experience shows that assets commonly considered to be liquid, such as Government securities and other money market instruments, could also become illiquid when the market and players are unidirectional. Therefore liquidity has to be tracked through maturity or cash flow mismatches. For measuring and managing net funding requirements, the use of a maturity ladder and calculation of cumulative surplus or deficit of funds at selected maturity dates is adopted as a standard tool. The format of the Statement of Liquidity is given in Annex I.

8.2 The Maturity Profile, as detailed in Appendix I, could be used for measuring the future cash flows of HFCs in different time buckets. The time buckets may be distributed as under:
i. 1 day to 30/31 days (one month)
ii. Over one month and upto 2 months
iii. Over 2 months and upto 3 months
iv. Over 3 months and upto 6 months
v. Over 6 months and upto 1 year
vi. Over 1 year and upto 3 years
vii. Over 3 years and upto 5 years
viii. Over 5 years and upto 7 years
ix. Over 7 years and upto 10 years
x. Over 10 years

8.3 HFCs holding public deposits are required to invest a prescribed percentage of their deposits in approved securities in terms of liquid asset requirement under Section 29B of the NHB Act, 1987. There is no such requirement for HFCs which are not holding deposits. Thus various HFCs would be holding in their investment portfolio securities which could be broadly classifiable as ‘mandatory securities’ (under obligation of law) and other ‘non-mandatory securities’. The HFCs holding deposits may be given freedom to place the mandatory securities in any time buckets as suitable for them. The listed non-mandatory securities may be placed in any of the “l day to 30/31 days (One month)”, “Over one month and upto 2 months” and “Over two months and upto 3 months” buckets depending upon the defeasance period proposed by HFCs. The unlisted non-mandatory securities (e.g., equity shares, securities without a fixed term of maturity, etc.) may be placed in the “over 10 years” bucket, whereas unlisted non-mandatory securities having a fixed term of maturity may be placed in the relevant time bucket as per the residual maturity. The mandatory securities and listed securities may be marked to market for the purpose of the ALM system. Unlisted securities may be valued as per the Prudential Norms.

8.4 Alternatively, the HFCs may also follow the concept of Trading Book which is as under:
i. The composition and volume are clearly defined;
ii. Maximum maturity/duration of the trading portfolio is restricted;
iii. The holding period does not exceed 90 days;
iv. Cut-loss limit(s) are prescribed;
v. Product-wise defeasance periods (i.e. the time taken to liquidate the position on the basis of liquidity in the secondary market) are prescribed;

HFCs which maintain such ‘Trading Books’ consisting of securities that comply with the above standards may show the trading securities under “1 day to 30/31 days (one month)”, “over one month and upto 2 months” and “over 2 months and upto 3 months” buckets on the basis of the defeasance periods. The Board/ALCO of the HFCs should approve the volume, composition, maximum maturity/duration, holding/defeasance period, cut loss limits, etc., of the ‘Trading Book’ . The remaining investments should also be classified as short term and long term investments as required under Prudential Norms.

8.5 A copy of the policy note recorded by the HFCs on treatment of the investment portfolio for the purpose of ALM and approved by their Board/ ALCO should be forwarded to the NHB.

8.6 Within each time bucket there could be mismatches depending on cash inflows and outflows. While the mismatches upto one year would be relevant since these provide early warning signals of impending liquidity problems, the main focus should be on the short-term mismatches viz., 1-30/31 days. HFCs, however, are expected to monitor their cumulative mismatches (running total) across all time buckets by establishing internal prudential limits with the approval of the Board/ Management Committee. The mismatches (negative gap) during 1-30/31 days, in normal course, should not exceed 15 per cent of the cash outflows in this time bucket. If an HFC, in view of its current asset-liability profile and the consequential structural mismatches, needs higher tolerance level, it could operate with higher limit sanctioned by its Board/Management Committee giving specific reasons on the need for such higher limit. The discretion to allow a higher tolerance level is intended for a temporary period, i.e. till September 30, 2002.

8.7 The Statement of Structural Liquidity (Annex I) may be prepared by placing all cash inflows and outflows in the maturity ladder according to the expected timing of cash flows. A maturing liability will be a cash outflow while a maturing asset will be a cash inflow. While determining the likely cash inflow/ outflows, HFCs have to make a number of assumptions according to their asset-liability profiles. While determining the tolerance levels, the HFCs may take into account all relevant factors based on their asset-liability base, nature of business, future strategies, etc. The NHB is interested in ensuring that the tolerance levels are determined keeping all necessary factors in view and further refined with experience gained in Liquidity Management.

8.8 In order to enable the HFCs to monitor their short-term liquidity on a dynamic basis over a time horizon spanning from 1 day to 6 months, HFCs may estimate their short-term liquidity profiles on the basis of business projections and other commitments for planning purposes. An indicative format (Annex II) for estimating Short-term Dynamic liquidity is enclosed.

Currency Risk
9. Floating exchange rate arrangement has brought in its wake pronounced volatility adding a new dimension to the risk profile of HFCs’ balance sheets having foreign assets or liabilities. The increased capital flows across free economies following deregulation have contributed to increase in the volume of transactions. Large cross border flows together with the volatility may render the HFCs’ balance sheets vulnerable to exchange rate movements.

Interest Rate Risk
10.1 The operational flexibility given to HFCs in pricing most of the assets and liabilities imply the need for the financial system to hedge the interest rate risk. Interest rate risk is the risk where changes in market interest rates might adversely affect an HFC’s financial condition. The immediate impact of changes in interest rates is on HFC’s earnings (i.e. reported profits) by changing its Net Interest Income (NII). A long-term impact of changing interest rates is on HFC’s Market Value of Equity (MVE) or Net Worth as the economic value of the assets, liabilities and off-balance sheet positions get affected due to variation in market interest rates. The interest rate risk when viewed from these two perspectives is known as ‘earnings perspective’ and ‘economic value perspective’, respectively. The risk from the earnings perspective can be measured as changes in the Net Interest Income (NII) or Net Interest Margin (NIM). There are many analytical techniques for measurement and management of interest rate risk. To begin with, the traditional Gap analysis is considered to be a suitable method to measure the interest rate risk in the initial phase of the ALM system. It is the intention of NHB to move over to the modern techniques of interest rate risk measurement like Duration Gap Analysis, Simulation and Value at Risk over time when HFCs acquire sufficient expertise and sophistication in acquiring and handling MIS.

10.2 The Gap or Mismatch risk can be measured by calculating Gaps over different time intervals as at a given date. Gap analysis measures mismatches between rate sensitive liabilities and rate sensitive assets including off-balance sheet positions. An asset or liability is normally classified as rate sensitive if:

i) within the time interval under consideration, there is a cash flow;
ii) the interest rate resets/reprices contractually during the interval;
iii) it is contractually pre-payable or withdrawable before the stated maturities;
iv) It is dependent on the changes in the Bank Rate by RBI.

10.3 The Gap Report should be generated by grouping rate sensitive liabilities, assets and off-balance sheet positions into time buckets according to residual maturity or next re-pricing period, whichever is earlier. All investments, advances, deposits, borrowings, purchased funds, etc. that mature/re-price within a specified time-frame are interest rate sensitive. Similarly, any principal repayment of loan is also rate sensitive if the HFC expects to receive it within the time horizon. This includes final principal repayment and interim instalments. Certain assets and liabilities carry floating rates of interest that vary with a reference rate and hence, these items get re-priced at pre-determined intervals. Such assets and liabilities are rate sensitive at the time of re-pricing. While the interest rates on term deposits are generally fixed during their currency, the tranches of advances are basically floating. The interest rates on advances could be re-priced any number of occasions, corresponding to the changes in PLR.

The interest rate gaps may be identified in the following time buckets:
i. 1 day to 30/31 days (one month)
ii. Over one month to 2 months
iii. Over 2 months to 3 months
iv. Over 3 months to 6 months
v. Over 6 months to 1 year
vi. Over 1 year to 3 years
vii. Over 3 years to 5 years
viii. Over 5 years to 7 years
ix. Over 7 years to 10 years
x. Over 10 years
xi. Non-sensitive

The various items of rate sensitive assets and liabilities and off-balance sheet items may be classified into various time-buckets, as explained in Appendix II and the Reporting Formats for short term dynamic liquidity and interest rate sensitive assets and liabilities are given in Annex II and Annex III, respectively.

10.4 The Gap is the difference between Rate Sensitive Assets (RSA) and Rate Sensitive Liabilities (RSL) for each time bucket. The positive Gap indicates that it has more RSAs than RSLs whereas the negative Gap indicates that it has more RSLs. The Gap reports indicate whether the institution is in a position to benefit from rising interest rates by having a positive Gap (RSA > RSL) or whether it is in a position to benefit from declining interest rates by a negative Gap (RSL > RSA). The Gap can, therefore, be used as a measure of interest rate sensitivity.

10.5 Each HFC should set prudential limits on individual Gaps in various time buckets with the approval of the Board/Management Committee. Such prudential limits should have a relationship with the Total Assets , Earning Assets or Equity. In addition to the interest rate gap limits, the HFCs may set the prudential limits in terms of Earnings at Risk (EaR) or Net Interest Margin (NIM) based on their views on interest rate movements with the approval of the Board/ALCO.

General
11.1 The classification of various components of assets and liabilities into different time buckets for preparation of Gap reports (Liquidity and Interest Rate Sensitivity) as indicated in Appendices I & II is the benchmark. HFCs which are better equipped to reasonably estimate the behavioural pattern of various components of assets and liabilities on the basis of past data/empirical studies could classify them in the appropriate time buckets, subject to approval by the ALCO/Board. A copy of the note approved by the ALCO/Board may be sent to the NHB.

11.2 The present framework does not capture the impact of premature closure of deposits and pre-payment of loans and advances on the liquidity and interest rate risks profile of HFCs. The magnitude of premature withdrawal of deposits during the periods of volatility in market interest rates is quite substantial. HFCs should therefore evolve suitable mechanism, supported by empirical studies and behavioural analysis, to estimate the future behaviour of assets, liabilities and off- balance sheet items to changes in market variables and estimate the probabilities of options.

11.3 A scientifically evolved internal transfer pricing model by assigning values on the basis of current market rates to funds provided and funds used is an important component for effective implementation of ALM System. The transfer price mechanism can enhance the management of margin i.e. lending or credit spread, the funding or liability spread and mismatch spread. It also helps centralising interest rate risk at one place which facilitate effective control and management of interest rate risk. A well defined transfer pricing system also provide a rational framework for pricing of assets and liabilities.

Appendices to ALM guidelines

Appendix I

B. INFLOWS

C. CONTINGENT LIABILITIES

NOTE

a) Any event-specific cash flows (e.g. outflow due to wage settlement arrears, capital expenses, income tax refunds, etc.) should be shown in a time bucket corresponding to timing of such cash flows.
b) All overdue liabilities be shown in the 1 to 30/31 days time bucket.
c) Overdue receivables on account of interest and instalments of standard loans/hire purchase assets/lease rentals should be slotted as below:

FINANCING OF GAPS

The negative gap (i.e. where outflows exceed inflows) in the 1 to 30/31 days time-bucket should not exceed the prudential limit of 15 per cent of outflows of each time-bucket and the cumulative gap upto the period should not exceed 15% of the cumulative cash outflows upto one year period. In case these limits are exceeded, the measures proposed for bringing the gaps within the limit, should be shown by a footnote in the relative statement.

Interest Rate Sensitivity Profile

B. ASSETS:

Annex I

(Amount in crore of rupees)

A. OUTFLOWS

B. INFLOWS

Annex II

Statement of short-term dynamic liquidity
(as on :              )

Name of the HFC :

(Amount in crore of rupees)

Annex III

(Amount in crore of rupees)

A. OUTFLOWS

B. INFLOWS