1. Read the balance sheet from the bank’s perspective
A customer deposit is an asset for the customer but a liability for the bank. A loan is a bank asset because it generates contractual cash inflows. Equity is the residual claim and loss-absorbing funding.
Assets = Liabilities + Equity. The following fictional teaching bank uses ₹ crore throughout. Balances are illustrative, not a regulatory reporting template.
| Assets | ₹ crore | Liabilities and equity | ₹ crore |
|---|---|---|---|
| Cash and central-bank balances | 100 | Customer deposits | 750 |
| Investments | 250 | Borrowings | 150 |
| Loans (net) | 600 | Other liabilities | 20 |
| Other assets | 50 | Equity | 80 |
| Total assets | 1000 | Total liabilities and equity | 1000 |
2. What each balance tells ALCO
| Item | Business role | ALM question |
|---|---|---|
| Cash / central-bank balances | Payments and reserve requirements | How much is immediately usable rather than restricted? |
| Investments | Income, liquidity and collateral | Are they liquid, unencumbered and eligible as collateral? What is their duration? |
| Loans | Core customer intermediation | When do cash flows arrive and rates reset? Can borrowers prepay? |
| Deposits | Core funding | How concentrated and rate sensitive are they? What withdrawals occur in stress? |
| Borrowings | Supplementary funding | When must they refinance, and can markets close? |
| Equity | Loss absorption | How much economic-value risk can the bank bear? |
3. Build the income statement
Assume average loans of ₹600 crore earn 9%; average investments of ₹250 crore earn 6%; average deposits of ₹750 crore cost 4%; and borrowings of ₹150 crore cost 6%. Other balances generate no interest in this simplified example.
| Line | Calculation | ₹ crore |
|---|---|---|
| Interest income | 600 × 9% + 250 × 6% | 69 |
| Interest expense | 750 × 4% + 150 × 6% | 39 |
| Net interest income (NII) | 69 − 39 | 30 |
| Other income | Assumed fees and other revenue | 8 |
| Operating expenses | Staff, premises and technology | 20 |
| Pre-provision operating profit | 30 + 8 − 20 | 18 |
| Provisions / impairment charge | Assumed | 6 |
| Profit before tax | 18 − 6 | 12 |
| Tax | Assumed 25% | 3 |
| Profit after tax | 12 − 3 | 9 |
4. Ratios that connect earnings with funding
| Ratio | Illustration | Interpretation |
|---|---|---|
| Net interest margin (NIM) | 30 ÷ 850 = 3.53% | NII divided by average interest-earning assets |
| Loan-to-deposit ratio | 600 ÷ 750 = 80% | One indicator of funding structure; not a liquidity guarantee |
| Return on assets | 9 ÷ 1,000 = 0.90% | PAT divided by assumed average total assets |
| Return on equity | 9 ÷ 80 = 11.25% | PAT divided by assumed average equity |
| Equity / assets | 80 ÷ 1,000 = 8% | Simple accounting ratio; not the Basel leverage or capital adequacy ratio |
For ROA and ROE, assume average total assets and equity equal the displayed balances. In real analysis use actual average balances and clearly defined annualisation conventions.
5. A deposit-price shock
If deposit rates rise by 1 percentage point immediately for a full year while all asset yields and borrowing costs stay unchanged, interest expense rises by ₹7.50 crore. NII falls from ₹30 crore to ₹22.50 crore; NIM falls to 2.65% on unchanged average earning assets.
This deliberately isolates one driver. Real deposits reprice at different times; loans may also reset. Deposit beta measures the extent to which a market-rate change passes into deposit pricing.
6. Beyond the reported balance sheet
Undrawn credit lines can become cash outflows, guarantees may be called, and derivatives can create collateral or settlement needs. ALM includes these contingent exposures. Contractual deposit maturity also differs from behavioural persistence: stable balances must be estimated and stress tested rather than assumed permanent.
Check your understanding
Why is NIM not the same as loan yield minus deposit cost?
NIM uses total NII and average interest-earning assets, combining multiple assets, liabilities and funding costs.
Can the bank fund a deposit withdrawal using accounting profit?
Only available cash or monetisable assets and funding can meet the payment. Accrued profit alone cannot.
7. Sources and uses of funds: reading the bank as a business
Sources: deposits, wholesale funding and equity
Retail deposits, corporate deposits, interbank borrowing and issued debt have different costs, concentrations and renewal patterns. Equity has no contractual redemption like a term deposit, but shareholders still require a return. Retained profits can add to equity.
Uses: reserves, liquid investments and customer lending
A bank allocates funding to payment balances, reserves, investment portfolios and loans. Some balances earn little or no interest but serve operational or regulatory needs. An asset’s carrying amount says little by itself about how much cash can be raised from it today.
Indian banking vocabulary
CASA means current-account and savings-account deposits. CRR concerns cash reserves with the RBI; SLR concerns specified liquid assets under applicable rules. Reserve balances, SLR holdings and eligible LCR HQLA are related concepts with different definitions and usability conditions. This lesson does not assume a current numerical CRR or SLR rate.
Reading connection: Choudhry, Chapter 1; CAIIB PAPER 2, uploaded PDF pp. 189–193, used for terminology rather than current regulatory parameters.
8. Stocks, flows and the three financial statements
| Statement | Question | ALM relevance |
|---|---|---|
| Balance sheet | What is outstanding on a particular date? | Funding mix, assets, leverage and equity |
| Income statement | What was earned and spent over a period? | NII, operating profit, provisions and PAT |
| Cash-flow statement | Why did cash change over the period? | Cash generation differs from accrued earnings |
A simple stock-flow bridge
Opening loans of ₹600 crore plus ₹120 crore of disbursements less ₹90 crore of principal repayments produce closing loans of ₹630 crore, before provisions, write-offs and other adjustments. Interest receipts belong in the cash-flow ladder but do not reduce principal unless the contract says so.
Profit does not all become new equity
Opening equity plus retained profit, capital issuance and other recognised equity movements produces closing equity. Dividends reduce retained earnings. A PAT figure cannot be added to capital automatically without considering distributions and applicable adjustments.
Reading connection: ALM NOTES, Chapter 7, stock-flow discussion; the stock-flow numbers are original illustrations.
9. Bullet loans, amortising loans and cash-flow timing
| Structure | Principal pattern | ALM implication |
|---|---|---|
| Bullet | Principal returns at final maturity | Funding remains tied up until maturity |
| Equal principal | Principal is repaid progressively | Funding requirement shrinks over time |
| Level instalment | A fixed payment combines interest and principal | Principal share generally rises as the loan amortises |
Two-year loan illustration
A ₹100 crore loan at 10% with equal annual principal repayments produces year-one cash of ₹60 crore (₹50 crore principal + ₹10 crore interest), then year-two cash of ₹55 crore (₹50 crore principal + ₹5 crore interest). A bullet loan at the same rate produces ₹10 crore, then ₹110 crore. Final maturity alone does not reveal the liquidity profile.
In a cash-flow ladder, include the relevant interest and principal payments. In a repricing ladder, identify the appropriate reset or repayment dates. Document conventions so the same flow is not counted twice.
Reading connection: ALM NOTES, Section 7.1.2.2. Newly constructed numbers.
10. Gross loans, provisions and economic losses
Gross exposure and net carrying amount
If gross loans are ₹620 crore and an illustrative impairment allowance is ₹20 crore, net loans are ₹600 crore. The exact presentation follows the accounting framework. An allowance is an accounting adjustment, not a separate pile of cash reserved for withdrawals.
Credit losses feed into ALM
A delayed or defaulted loan can reduce expected cash inflows, interest income and capital. ALM should reflect realistic collections in liquidity and earnings scenarios, while the credit-risk function measures credit quality and expected losses.
Provision expense versus write-off
A provision charge reduces profit when recognised. A later write-off can use an existing allowance; it need not create the same expense again. Collections, accounting recognition and funding effects occur on different timelines.
Reading connection: Choudhry, bank business and capital discussion; ALM NOTES, Section 7.1.1.
11. Book equity, economic equity and regulatory capital
| Concept | Purpose | Important distinction |
|---|---|---|
| Book equity | Residual under accounting rules | Depends on recognition and valuation rules |
| EVE | Discounted value of relevant banking-book cash flows | Model-dependent and different from the share price |
| Regulatory capital | Eligible capital under prudential rules | Includes prescribed definitions and deductions |
| Market value of equity | Investors’ valuation of shares | Reflects expected future performance and risk |
Banking book and trading book
These prudential books reflect different purposes and risk treatments. They are not simply identical to accounting valuation categories. Assets carried at amortised cost can retain interest-rate economic-value exposure even when their market-value changes do not immediately enter reported profit.
Reading connection: ALM NOTES, Sections 7.1.1.1–7.1.1.3; Choudhry, 2011, Chapter 1.
12. A return-on-equity bridge and the cost of equity
ROE = ROA × equity multiplier
Using the teaching bank, ROA = 9/1,000 = 0.90% and the equity multiplier = 1,000/80 = 12.5. Their product is ROE = 11.25%. Higher leverage can lift ROE for a given ROA, but also increases vulnerability to losses.
Accounting profit versus value creation
Assume shareholders require 13% on the ₹80 crore equity. The annual equity charge is ₹10.40 crore. PAT of ₹9 crore gives a simplified residual income of −₹1.40 crore. Positive accounting profit therefore does not necessarily meet the required return. This is an illustrative value-creation screen, not a regulatory capital calculation.
Reading connection: Dermine & Bissada, Stages 2–3. Calculations use this series’ original teaching bank.
13. Ratio definitions and common interpretation errors
Use a stated denominator for every ratio. This series defines NIM as NII divided by average interest-earning assets. Some older notes use total assets; those figures are not directly comparable. A simple loan–deposit interest spread is also different from NIM.
Compare consistent periods, averages, annualisation, accounting rules and business mixes. A higher CASA share may help funding economics, but it does not prove that deposits are stable in stress. A higher reported NIM can reflect compensation for greater credit or funding risk.
Reading connection: The uploaded CAIIB compilation uses alternative NIM denominators. Definitions are made explicit here to avoid mixing conventions.
Materials used to expand this series
Selected relevant sections were reviewed and synthesised into original explanations and new examples. The source books and notes are not reproduced.
| Material | Reviewed section / use |
|---|---|
| Moorad Choudhry: An Introduction to Banking, Liquidity Risk and Asset–Liability Management (2011) | Chapter structure; ALCO policy and reporting, Chapter 7, printed pp. 224–229 |
| Moorad Choudhry: An Introduction to Banking, Principles, Strategy and Risk Management, 2nd edition | Chapter 1 business model, strategy, capital and financial statements |
| Jean Dermine and Youssef F. Bissada: Asset & Liability Management (2002) | Value creation, ROE and Stage 5 transfer-pricing discussion |
| ALM NOTES: Chapter 7, Asset Liability Management Risk | Financial statements, ALCO, liquidity gaps, amortisation and balance-sheet scenarios |
| Asset Liability Management: Compiled Practical Resources | Kallur’s CRO perspective, governance, FTP, policy and contingency funding |
| CAIIB PAPER 2 | Selected banking statements and coordinated balance-sheet management; historical definitions reviewed critically |
| Gurnani: Asset Liability Management In The Banks | Two-page conceptual overview; historical buckets not treated as current requirements |
| Handbook of Asset and Liability Management upload | Seven-page contents extract only; used as a reading map |
| RBI_2008-09_ | Historical FX circular; scope and date distinguished from current ALM requirements |
Sources and further reading
Regulatory sources support the concepts; requirements differ by jurisdiction and bank category. Check amendments and commencement provisions before applying a rule.
- RBI: Commercial Banks – Asset Liability Management Directions, 2025 — liquidity governance, intraday liquidity, LCR, NSFR and interest-rate risk.
- Basel Framework — LCR, NSFR and IRRBB; SRP98 application guidance explains earnings and economic-value perspectives.
- Federal Reserve: SR 10-6, Interagency Advisory on Interest Rate Risk Management.
- EBA: Guidelines on IRRBB and CSRBB (EBA/GL/2022/14).
Recommended academic reading
The following bibliography was supplied for this series. The full books were not available for direct consultation; no chapter or page claims are made.
- Joël Bessis (2015), Risk Management in Banking, 4th edition, Wiley — recommended for integrated banking risk, liquidity and interest-rate risk.
- Dimitris N. Chorafas (2002), Asset/Liability Management for Banking Institutions, Elsevier — recommended for ALM measurement and balance-sheet modelling.
- Andrea Resti and Andrea Sironi (2007), Risk Management and Shareholders’ Value in Banking, Wiley — recommended for risk measurement, value and capital allocation.
Continue learning
- 1. Introduction to Asset Liability Management in Banks
- 2. Understanding Banks’ Balance Sheet and Income Statement
- 3. ALM Process
Educational illustrations use fictional data. Prof. V. Ravichandran · The Mountain Path Academy.