ASSETS LIABILITY MANAGEMENT IN BANK Assets liability management has today become the most topical subject of any

financial institution. It encompasses the analysis and development of goals and objectives, the development of long term strategic plans, periodic profit plans and rate sensitivity management. In one way or another it has always been the function or responsibility of Treasury and other financial/ strategic department is being established and assets liability management department are being formed within financial institution. These committees are often given extraordinary powers regarding the mix and match of assets and liabilities and have large influence in winding up activities which do not fit business strategy. It is true that banks create both assets and liabilities in their day-to-day operations, but it is also equally true that risk management in bank is keener to manage their assets rather than their liabilities. In fact, for some time, bankers were happy to keep an eye on their assets acquisition and treated the liability as granted. Of late, the mindset has changed and banks increasingly shown equal, if not more, interest in liability management. In fact, bank’s main business is to manage risk. Importantly, liquidity and interest risk management constitutes the core business of banks. To be more precise, banks are in the business of maturity transformation. They accept deposits of different maturities and advance loan of different maturities. Balancing and adjusting maturity period of deposits and loans from the core business activity of banks. If this activity of a bank is analyzed, one may observe that banks also transfer the risk appetite of customers to each other through market operation. These activities of banks result in management of liquidity and interest risk in their operations. In early day’s bank were mongering risks by having in-depth knowledge of customers. In day-to-day operation, it is inevitable for bank to face liquidity imbalance due to various reason.

ASSETS LIABILITY MANAGEMENT IN BANK Traditionally, banks and insurance companies used accrual system of accounting for all their assets and liabilities. They would take on liabilities - such as deposits, life insurance policies or annuities. They would then invest the proceeds from these liabilities in assets such as loans, bonds or real estate. All these assets and liabilities were held at book value. Doing so disguised possible risks arising from how the assets and liabilities were structured. Consider a bank that borrows 1 Core (100 Lakhs) at 6 % for a year and lends the same money at 7 % to a highly rated borrower for 5 years. The net transaction appears profitablethe bank is earning a 100 basis point spread - but it entails considerable risk. At the end of a year, the bank will have to find new financing for the loan, which will have 4 more years

US regulations which had capped the interest rates so that banks could pay depositors. Increasingly banks and asset management companies started to focus on Asset-Liability Risk. were abandoned which led to a migration of dollar deposit overseas. such mismatches tended not to be a significant problem. Equitable then invested the assets short-term to earn the high interest rates guaranteed on the contracts. it couldn't get even close to the interest rates it was paying on the GICs. the bank would earn Rs 100. who were accustomed to thinking in terms of accrual accounting. Because the firms used accrual accounting. the bank may have to pay a higher rate of interest on the new financing than the fixed 7 % it is earning on its loan. Eventually. Firms responded by forming assets-liability management ( ALM ) department to assess these assets-liability risk. so losses due to asset-liability mismatches were small or trivial. as the USD yield curve was inverted with short-term interest rates sky rocketing. but it could not solve the problem. it had to demutualize and was acquired by the Axa Group. Accrual accounting could disguise the problem by deferring losses into the future. It was that capital might be depleted by narrowing of the difference between assets and liabilities and that the values of assets and liabilities might fail to move in tandem. Accrual accounting does not recognize this problem. Firms had no options but to accrue the losses over a subsequent period of 5 to 10 years.before it matures. it resulted in more of crippled balance sheets than bankruptcies. The problem in this example was caused by a mismatch between assets and liabilities. Suppose. Managers of many firms." During the early 1980s. Some firms suffered staggering losses. Many firms intentionally mismatched their balance sheets and as yield curves were generally upward sloping. The problem was not that the value of assets might fall or that the value of liabilities might rise. banks could earn a spread by borrowing short and lending long. Asset-liability risk is predominantly a leveraged form of risk. at the end of a year. which drew attention. Things started to change in the 1970s. The bank is in serious trouble. were slow to recognize this emerging risk.000 in the first year although in the preceding years it is going to incur a loss. The firm was crippled. and so small percentage changes in assets or liabilities can translate into large percentage changes in capital. Based upon accrual accounting. which ushered in a period of volatile interest rates that continued till the early 1980s. Prior to the 1970's. One example. . When the Equitable had to reinvest. If interest rates have risen. It is going to earn 7 % on its loan but would have to pay 8 % on its financing. the company sold a number of long-term Guaranteed Interest Contracts (GICs) guaranteeing rates of around 16% for periods up to 10 years. was that of US mutual life insurance company "The Equitable. But short-term interest rates soon came down. Interest rates in developed countries experienced only modest fluctuations. The capital of most financial institutions is small relative to the firm's assets or liabilities. an applicable 4-year interest rate is 8 %.

THUS. PURPOSE OF ASSETS LIABILITY MANAGEMENT IS TO ENHANCE THE ASSET AND LIABILITIES AND FURTHER MANAGE THEM. SUCH A PROCESS WILL . maturity. rate sensitivity. quality and liquidity of assets and liabilities as a whole so as to attain a predetermined acceptable risk/reward ratio.PURPOSE AND OBJECTIVES OF ASSETS LIABILITY MANAGEMENT An effective Asset Liability Management technique aims to manage the volume mix.

2. Liquidity is ensured by grouping the assets/liabilities based on their Maturing profiles. there are often maturity mismatches.OBJECTIVE OF ASSETS LIABILITY MANAGEMENT At micro – level the objectives of Assets Liability Management are two folds. This exercise would indicate whether the institution is in a position to benefit from rising interest rates by having a positive gap (assets > liabilities) or whether it is in a position to benefit from declining interest rates by a negative gap(liabilities > assets). It aims at profitability through Price Matching while ensuring liquidity by means of maturity matching. 1. The gap in then assessed to identify future financing Requirements. which may to a certain extent affect the expected result. . Price Matching basically aims to maintain spreads by ensuring that deployment of liabilities will be at a rate higher than the costs. However.

the monitoring of economic and money market trends is key to liquidity planning. Internal liquidity risk relates largely to the perception of an institution in its various markets: local. Funds management represents the core of sound bank planning and financial management. promptly and at a reasonable cost. Therefore. techniques.Liquidity Management Liquidity represents the ability to accommodate decreases in liabilities and to fund increases in assets. Sound financial management can minimize the negative effects of these trends while accentuating the positive ones. Although funding practices. An organization has adequate liquidity when it can obtain sufficient funds. regional. Sound liquidity risk management should address both types of exposure. a bank may be forced to restructure or acquire additional liability under adverse market conditions. either by increasing liabilities or by converting assets. Liquidity exposure can stem from both internally (institution-specific) and externally generated factors. and norms have been revised substantially in recent years.ASSET-LIABILITY MANAGEMENT APPROACH ALM in its most apparent sense is based on funds management. Determination of the adequacy of a bank's liquidity position depends upon an analysis of it’s: • Historical funding requirements • Current liquidity position • Anticipated future funding needs • Sources of funds • Present and anticipated asset quality • Present and future earnings capacity • Present and planned capital position As all banks are affected by changes in the economic climate. If liquidity needs are not met through liquid asset holdings. A. External liquidity risks can be geographic. both interest rate and credit risks. reflected in the balance sheet and off-balance sheet activities in the case of a bank. national or international. it is not a new concept. Liquidity is essential in all organizations to compensate for expected and unexpected balance sheet fluctuations and to provide funds for growth. The price of liquidity is a function of market conditions and market perception of the risks. Management must also have an effective contingency plan that identifies minimum and . Funds management is the process of managing the spread between interest earned and interest paid while ensuring adequate liquidity. systemic or instrument-specific. which have been discussed briefly. funds management has following three components.

C. The alternative costs of available discretionary liabilities can be compared to the opportunity cost of selling various assets. But banks. Asset Management Many banks (primarily the smaller ones) tend to have little influence over the size of their total assets. However. is of primary importance in asset management. An institution that maintains a strong liquidity position may do so at the opportunity cost of generating higher earnings. management must carefully weigh the full return on liquid assets (yield plus liquidity value) against the higher return associated with less liquid assets. a relatively low allowance for liquidity is necessary Additionally. To maximize profitability. concentrate on adjusting the price and availability of credit and the level of liquid assets. The major difference between liquidity in larger banks and in smaller banks is that larger banks are better able to control the level and composition of their liabilities and assets. or may be heavily depreciated because of interest rate changes. or how "salable" the bank's assets are in terms of both time and cost. The marginal cost of liquidity and the cost of incremental funds acquired are of paramount importance in evaluating liability sources of liquidity . The decision whether or not to use liability sources should be based on a complete analysis of seasonal. the availability of asset and liability options should result in a lower liquidity maintenance cost. Furthermore. If deposit accounts are composed primarily of small stable accounts. The cost of maintaining liquidity is another important prerogative. The amount of liquid assets a bank should hold depends on the stability of its deposit structure and the potential for rapid expansion of its loan portfolio. which rely solely on asset management. In addition to supplementing asset liquidity. or other factors may cause aggregate outstanding loans and deposits to move in opposite directions and result in loan demand. and the costs involved. cyclical. Once liquidity needs have been determined. Liquid assets enable a bank to provide funds to satisfy increased demand for loans. liability management or a combination of both. assets that are often assumed to be liquid are sometimes difficult to liquidate. which exceeds available deposit funds. cyclical. A bank relying strictly on asset management would restrict loan growth to that which could be supported by available deposits. For example. This does not preclude the option of selling assets to meet funding needs. at less than book value. Asset liquidity. Income derived from higher yielding assets may be offset if a forced sale.maximum liquidity needs and weighs alternative courses of action designed to meet those needs. the holding of liquid assets for liquidity purposes is less attractive because of thin profit spreads. is necessary because of adverse balance sheet fluctuations. and conceptually. and other factors. management must decide how to meet them through asset management. The ability to obtain additional liabilities represents liquidity potential. Liability Management Liquidity needs can be met through the discretionary acquisition of funds on the basis of interest rate competition. investment securities may be pledged against public deposits or repurchase agreements. liability sources of liquidity may serve as an alternative even when asset sources are available. management must consider the current ratings by regulatory and rating agencies when planning liquidity needs. B. Seasonal.

managementparadise. .

Sign up to vote on this title
UsefulNot useful